Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under

the relevant copyright,

designs and patents acts, this publication may only be reproduced, stored or transmitted, in any form or by any means, with the priorpermission in writing of the publishers.

SHAREHOLDERVALUEDEMYSTIFIED

MARIA BARBERA MCom (UNSW) is the research officer of the Australian

Centre for Management Accounting Development (ACMAD) at theUniversity of New South Wales. Her position involves the preparation andcommissioning of research documents that promote organisationalinnovation, effective resource management, and inter-organisational learning.RODNEY COYTE BCom (Melb) MCom (UNSW) AACS joined theSchool of Accounting at the University of New South Wales in 1992, andlectures there in business strategy, management and management accounting.He previously held a number of senior management positions includingbusiness planning manager and information technology manager for a unit ofthe Mars Corporation.

THE AUSTRALIAN CENTRE FOR MANAGEMENT ACCOUNTING DEVELOPMENT

(ACMAD) is a member-driven and member-financed network of almost 100organisations and universities. Its mission is to stimulate and facilitatelearning about the innovative management of organisational resources. Thisseries is one expression of its mission. ACMAD welcomes inquires. Furtherinformation about the Centre is provided on its website at:www.ace.unsw.edu.au/acmadTHE INSTITUTE OF CHARTERED ACCOUNTANTS IN AUSTRALIA believes that theStrategic Resource Management series will contribute to the clarification of arange of significant issues facing managers and business professionals in thefuture. The practical insights and distinctive perspectives offered will greatlybenefit our members and will add value to anyone who is a strategic businessthinker.Other books in the series:Controls in Strategic Supplier RelationshipsSuresh Cuganesan, Michael Briers and Wai Fong ChuaInnovative Management Accounting: Insights from practiceMaria Barbera, Jane Baxter and William BirkettOrganisational Learning and Management Accounting Systems:A study of local governmentLouise Kloot, Maria Italia, Judy Oliver and Albie Brooks

STRATEGIC RESOURCE MANAGEMENT

Maria Barbera

Rodney Coyte

SHAREHOLDERVALUEDEMYSTIFIEDAN EXPLANATION OFMETHODOLOGIES AND USE

A UNSW Press book

Published byUniversity of New South Wales Press LtdUniversity of New South WalesSydney 2052 Australiawww.unswpress.com.au ACMAD 1999First published 1999This book is copyright. Apart from any fair dealing for the purpose of private study, research,criticism or review, as permitted under the Copyright Act, no part may be reproduced by anyprocess without written permission. Inquiries should be addressed to the publisher.National Library of AustraliaCataloguing-in-Publication entry:Barbera, Maria.Shareholder value demystified: an explanation of methodologies and use.Bibliography.ISBN 0 86840 697 X.1. Corporations Valuation. 2. Corporations Valuation Accounting.I. Coyte, W. (Rodney William). II. Title. (Series: Strategic resource management).332.63221Printer BPA, Melbourne

COCA-COLA AMATIL LIMITED48

THE CAPITAL ASSET PRICING MODEL64

THE PERPETUITY METHOD 67ADJUSTMENTS TO CAPITAL AND NOPAT IN EVA 67

REFERENCES 68

STRATEGIC RESOURCE MANAGEMENT

Organisations are devices for creating value through the effective use of resources.While they need to create value for all contributors of resources, a premium is placedon value creation for customers and shareholders. After all, an organisation is unlikelyto be able to offer inducements to other resource contributors if it does not providevalue to its customers. Also, shareholders are aware that failure in value creation forcustomers will be reflected in the value that they can receive. Value creation forcustomers and shareholders, then, is broadly regarded as the litmus test for judgingorganisational effectiveness.Value creation by organisations takes place against a backdrop of fast movingcompetition in resource and service markets, and increasingly rapid shifts in the valueexpectations of customers. Under these conditions it is insufficient to meet or beatthe competition with present service offerings; new service offerings have to beinvented and made competitive, as previous offerings cease to be serviceable and arethus devalued.As service offerings change, so will the materials, technologies, skills andprocesses that are needed to produce them. New service offerings require differentconstellations of resources and new relationships with new resource contributors.An organisation's strategies define how it proposes to create value for customersin terms of its service offerings over the immediate period and the opportunities itseeks over a longer term. Whether or not an organisation will be successful in theseendeavours will depend on its capabilities for doing so.Strategies, then, have to deal with both the known (the creation of value throughpresent service offerings) and the unknown (the invention of service offerings thatwill create value in an as yet unknown future). And capabilities need to sustain boththe organisation's present effectiveness in offering services and its future renewal bycapitalising on opportunities as they emerge.An organisation's success in strategy realisation or renewal will be dependent on itseffectiveness and creativity in managing resources. This places a premium on strategicresource management and on new ways of understanding organisational resources,resourcing and resourcefulness. What are an organisation's resources, what forms dothey take and how can they be used effectively and not wasted? What constellations ofresources constitute strategic capabilities, useable now in meeting the competition andconverting possibilities into future opportunities? And what strategic capabilities aresufficiently distinctive to constitute the core competences underlying an organisation'scontinuing identity?These questions are answered in the Strategic Resource Management Series. Eachvolume will address them in relation to particular subject matter, drawing on relevanttheories and providing illustrations from contemporary organisational practice.

PREFACE

The interest of organisations in shareholder value has been amply

demonstrated by the number of people attending ACMAD activities andother conferences on the subject, and by the frequent references to themethodologies in the financial press. ACMAD feels that, although interested,many firms are confused about the different methodologies and the claimsmade for them. This report is an attempt to redress this uncertainty.The aim of the report is to provide relevant information aboutshareholder value techniques and their use in value-based approaches toperformance measurement, thereby assisting readers in their consideration ofrelevant issues. Specifically, this book:

identifies the inadequacies of traditional accounting measures as

performance measuresexplains the rationale for the shareholder value approachdescribes and compares three of the major methodologies, highlightingtheir commonalities and differencesidentifies the ways in which consideration of shareholder value can beapplied to strategy selection and implementationplaces shareholder value methodologies within organisations'frameworks for value creation, through a discussion of value-basedmanagementexamines the role of shareholder value measurements in incentivecompensation decisionsrelates the experiences of some Australian corporations which haveadopted shareholder value techniques.

In addressing these areas, the report not only explores and compares themajor methods, but also clarifies the purpose and use of the concept ofshareholder value in both strategic and operational decision making. Theconclusion considers the advantages and limitations of shareholder valueanalysis. This report should be of value to a range of managers.

AcknowledgmentsThe authors wish to thank the organisations who agreed to participate in thisproject and the senior staff members of those organisations who gave theirtime and assistance. Thanks are also due to Mark Joiner (Boston ConsultingGroup), Denis Kilroy (KBA Consulting Group), the reviewers, and ProfessorsBill Birkett and Wai Fong Chua for their helpful comments.The opinions expressed in this document are those of the authors only anddo not necessarily represent the views of the National or State committeesof ACMAD.

INTRODUCTION

The quest to create value at an increasing rate over the long term is the focus ofmost contemporary business enterprises. While the term `value' means differentthings to different stakeholders, the emphasis in this report is on the creationand measurement of value for one specific stakeholder group: shareholders.For shareholders, value is created when a business, through the efficientmanagement of its resources, earns a return greater than the cost of the capitalemployed to generate that return. This is not a new concept, but is one thathas attracted the intense focus of managers and investors over the last decade.Shareholders are interested in the cash increments, over and above outlay, tobe received over the life of their investment: that is the dividends and capital gaindelivered. Whether or not these increments represent value is related to the riskassociated with the investment investors will require a higher return frominvestments that are seen to be risky. Arguably, share market prices incorporateexpectations about the value creation potential and the risk of corporations.In view of the imperative for organisations to create value for their shareholders, how do organisations measure the value created by their operations?Traditionally, such measurement used accountancy-based indicators such asearnings, return on investment and return on equity. However, these measuresare not based on cash-flow and do not take into account the full cost ofcapital (that is, the costs of equity and of debt). The suggested inadequaciesof accountancy-based measures are summarised in Chapter 2.New methodologies include three which support the theory that a valuemaximising organisation will be interested only in investments which, indiscounted cash flow terms, offer a return greater than the cost of capital.These three are:

Shareholder Value Analysis (as proposed by Alfred Rappaport)

These are not the only methodologies available. Indeed, every consultingfirm appears to have devised its own variation. Nevertheless, these threeincorporate the principles of shareholder value measurement and aresufficiently different to be of interest. They are described in Chapters 3 to 5respectively and compared in Chapter 6.Having measured the shareholder value achieved through their operations,organisations are faced with the need for initiatives and actions which will impactfavourably on that value into the future. To this end, they develop strategies (thatis, patterns of resource allocation) and select those that, if implemented successfully, will optimally increase shareholder value. Again, shareholder value

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SHAREHOLDER VALUE DEMYSTIFIED

metrics are used: for example, to calculate the shareholder value that can beadded by acquisitions or divestments, select between synergistic opportunities,make decisions about resource allocation, choose between potential productor service market portfolios and projects, and so forth.The concept of shareholder value is being adopted by many Australiancompanies. It is seen as facilitating, indeed enabling, growth, restructuring,product and customer selection, and profitability. Much depends, however,on how well it is understood, how well it is integrated into organisationalthinking, strategic planning, decision-making, and operational activities, andhow efficiently it is used as a motivational device. Understanding isfacilitated by training, and integration is assisted by the introduction of valuebased management concepts. Motivation is sponsored by the introduction ofvalue-based compensation which effectively links performance andshareholder value. Such aspects of value-based management are coveredbriefly in Chapter 7.Value, however, is not created by merely measuring financialperformance. Organisations create value in their product or service markets inthe face of competition, ever shorter life cycles, and high levels ofuncertainty and ambiguity. In today's world, value creation depends oninnovation, creativity and collective organisational capability (including thequality of management). While shareholder value approaches may providedescription and give structure to organisational effort, they cannot substitutefor the wellspring of creativity. Shareholder value creation is, after all, anoutcome of organisational efforts and accomplishments.

A note on terminology, nomenclature and tradenames

The terminology used in this area is extensive and rapidly changing. Thereare two reasons for this. Firstly, while shareholder value techniquesdeveloped by individuals or organisations were given specific names (whichare in some cases trademarked), the concepts which underlie theseproprietary names have now become generic. Thus people and journalarticles use words such as `economic value', `value metrics', `shareholdervalue' without meaning to specifically refer to one or any of the proprietarymethodologies available.Secondly, earlier books and articles principally addressed theshortcomings of accounting numbers, the rationale for shareholder value, andthe application of shareholder value metrics to strategic choices. The focus ofshareholder value has now shifted from the mathematics of shareholder valueto its implementation, management and distillation throughout theorganisation.In this report, proprietary systems are indicated by the use of propernames. For instance the Stern Stewart trademarked version is referred to asEconomic Value Added or EVA. Where terms are used generically, lowercase is adopted.

CHAPTER

1SHAREHOLDERVALUE IN CONTEXT

Organisational stakeholders`An organisation is an association of productive assets (including individuals)which voluntarily come together to obtain economic advantages' (Barney1997, p. 31). Thus, owners supply capital which is used to acquire assets,customers provide revenue, employees contribute expertise, governmentprovides services, the community allows organisations to exist and confersadvantages such as limited liability on corporations, suppliers provide inputsto production, and so on. Each of these groups can, however, withdraw itscontribution from the organisation and, indeed, will do so unless the valuereceived (in terms of income or satisfaction) is, after adjusting for risk, atleast as large as that which could be expected from similar alternatives.In order to ensure that shareholders and the owners of other productiveassets are willing to continue to remain associated with it, the organisationseeks an equilibrium between the `inducements' it must pay in return for the`contributions' it receives. The word `equilibrium' suggests that theorganisation will seek to achieve some sort of a balance between its variousstakeholder groups.

Value trade-offsOne problem is that `value' is what a stakeholder group cares about; anddifferent groups care about different things. The community values high

SHAREHOLDER VALUE DEMYSTIFIED

standards of corporate citizenship, and the provision of employment and

opportunity; employees value personal involvement and job satisfaction, aswell as remuneration; shareholders value investment return and capital gain;customers value quality, service, price, and so on. An organisation can rarelyimplement strategies that fully satisfy the performance demands of all groups,at least in the short term. Furthermore, the task of isolating and measuringperformance for each stakeholder group would be overwhelming. For thesereasons, the interests of certain stakeholders are usually emphasised over theinterests of other stakeholders over time. Current organisational thinkingconcentrates on the creation of shareholder value.Copeland, Koller and Murrin (1996) justify this emphasis on shareholdervalue (as opposed to the weighted approach, which considers all stakeholdergroups, adopted in continental Europe and some Asian countries) bydemonstrating that shareholder value and national economic performance (asmeasured by GDP, productivity and job creation) are positively correlated:Empirical evidence indicates that increasing shareholder value does not conflictwith the long-run interests of other stakeholders. Winning companies seem tocreate relatively greater value for all stakeholders: customers, labor, thegovernment (via taxes paid), and suppliers of capital (p. 22)All claimants benefit when shareholders . . . use complete information and theirdecision-making authority to maximise the value of their own claim. The alignmentof information and incentives within the equity claim is what makes this form oforganisation (the modern corporation) the best competitive mechanism.Shareholders maximise the value of other claims in the attempt to maximise theirown value (p. 27).

Cash generationIn addition to creating value for the providers of capital (in order to competewith alternative investment opportunities), an organisation needs the cashgenerating ability to satisfy the financial claims of its stakeholders. Itgenerates cash from operating its businesses: receiving revenue, and payingfor investments in assets and expenses. Any additional cash required isobtained from two external sources: debt and equity. Both borrowing powerand the market price of shares depend on the organisation's cash-generatingability. Lenders will not be prepared to deal, or will require a premium rent, ifthe risk of non-compliance with the terms of the loan is high. Equity holderswill be unwilling to provide additional funds if their prospective reward, inthe form of dividends and capital gain, is inadequate or uncertain whencompared with other investment opportunities.

SHAREHOLDER VALUE IN CONTEXT

Organisational strategiesIn order to create value for their constituencies, organisations develop strategies:patterns of resource allocation that enable them to maintain or improve theirperformances in particular product and service markets. Organisationalstrategies are typified in management literature in three major ways:

as a hierarchical structure, where the mission and objectives are

determined by top management, business-level strategies are decidedupon at business unit level, and appropriate tactics are devised atoperational levelas an on-going process through which a firm analyses its environment,resources and capabilities to determine how it might gain competitiveadvantage and leverage resources to increase that advantageas some combination of both.

Whichever approach is adopted, the identification of possible strategies

does not obviate the need to select some strategies rather than others.Shareholder value metrics calculate the impact of potential product/servicemarket portfolio choices, strategy alternatives, synergistic opportunities,resource allocation decisions, project choices and so forth on organisationalvalue. This is done by calculating the potential net cash flows arising overtime and adjusting them (by discounting, or subtracting a capital charge) forthe cost of capital. It thus enables the selection of strategies which will, ifthey succeed as planned, optimally increase shareholder value.Similarly, decisions are made at business unit and operating levels aboutmarkets, technologies and processes, and the allocation of resources (people,technology, and capital) to activities, products or customer segments. Here,shareholder value analysis guides the creation of value through theidentification and management of value drivers (those factors which have thegreatest potential to enhance or diminish shareholder value).Once strategies are defined, the real work starts. How are these strategiesto be implemented? What are the amounts and timing of revenue streamsarising from a project (for a firm is basically a collection of short- and longterm projects)? What resources are required? What technologies will beused? What are the trade-offs between shareholder and customer value? Howare costs to be measured and controlled? What are the critical performancefactors? How are they to be measured? How can organisational effort befocused on shareholder value?

Driving value creation

The ability to measure value is a technical exercise in the use of value-basedfinancial performance metrics (such as those in Chapters 3 to 5) applied to

SHAREHOLDER VALUE DEMYSTIFIED

either the whole organisation, to units within it, or to projects within units.Measuring value more accurately is an important exercise and can promoteunderstanding of what outcomes will have an impact on value. However,measurement in itself will not create shareholder value.In today's dynamic world, shareholder value creation depends oninnovation, creativity, and collective organisational capability (including thequality of management). Techniques such as `value-based management' and`economic value management' are suggested as means of nurturing thecapabilities of an organisation, promoting the ability to put those capabilitiesto good effect (for instance, by acquiring strategic assets, developing internaland external relational contracts, co-ordinating diverse skills and/orintegrating streams of technology), and achieving the integration ofshareholder value concepts and strategic and operational decision-making.Incentive compensation is believed to have an important role in encouragingthe creation of shareholder value.

Organisational performanceExternal and internal evaluationsFrom a shareholder's perspective, the return on investment outlay in anorganisation's ordinary shares is the present value of the dividends receivedthroughout the life of the investment and the capital gain achieved on sale.Whether these returns constitute `value' depends on the opportunity cost ofrisk-free investment plus a margin for the risk related to the specificinvestment.Stock prices on share markets are not determined solely by the profit pershare, or the net tangible assets per share. They reflect not only the currentstate of the company but also the expectations of investors regarding acompany's future growth, risk and return profile and the quality of itsmanagement, in view of the expected future state of the economy and therelevant industry.The various shareholder value techniques described in the followingchapters have been designed to reflect shareholder thinking. One test of theirvalidity is the correlation between the result of the shareholder valuecalculation (whether undertaken inside the firm or by an external investor)and the stock market price. This issue is considered in Chapter 6.From the viewpoint of the organisation's management, shareholder valuetechniques are utilised, not only in the selection of strategies which willenhance value, but in the implementation and management of thosestrategies. Thus, employees at all levels of the organisation are trained in the

SHAREHOLDER VALUE IN CONTEXT

importance of shareholder value concepts and the role each can play instrategy selection and strategy implementation.

Relativities and benchmarks

Shareholder value added, as measured by movements in the prices of stockson the share market, provides organisations with an external benchmark.Such movements will not always be positive: prices may move up and downeither broadly across stocks or across stocks operating in particular industriesor sectors. However, whether prices are falling or rising, corporations canassess their relative performance against that of their competitors or peers,attempt to identify the factors or capabilities that separate top performingcompanies from others, and apply this understanding to the creation ofreform programs targeted at key drivers of shareholder value or to theidentification of higher value strategies (Kilroy 1997/1998).Internally, shareholder value analysis can be used to assess and comparethe value created by individual business units or segments, and to reconsidercurrent strategies where appropriate.The issues that arise from the above discussion are:

How should the change in a company's shareholder value be measured?

How can the measure be used in evaluating and selecting strategies?How can the measure be used in guiding strategy implementation?How can the measure be used to drive performance improvements andwealth creation?

CHAPTER

2THE INADEQUACIESOF TRADITIONALACCOUNTING MEASURES

Accruals, generally accepted accounting principles (GAAP)

and cash flowThe most common way of measuring corporate performance is through theuse of accounting measures. This is understandable: the information isextensive and readily available; and produced in compliance with rules(accrual accounting and generally accepted accounting principles or GAAP)which are claimed to permit comparisons across firms.Accounting approaches typically use ratios derived from balance sheetsand profit and loss statements to assess performance. Common ratios arethose directed towards assessing:

profitability (with some measure of profit in the numerator and some

measure of firm size or assets in the denominator)liquidity (that focus on the ability of a firm to meet its short-termobligations)leverage (that focus on the level of a firm's indebtedness)activity (that focus on the level of activity, usually in relation to time).

Other ratios, such as earnings per share (EPS) and price over earnings,combine accounting numbers with share market information.

THE INADEQUACIES OF TRADITIONAL ACCOUNTING MEASURES

Criticisms of the use of accounting-generated ratios, as bases for decisionmaking by internal and external users, include the following three:

Accrual accounting based measures do not equate with the cashgenerating ability of the firm.GAAP allows management some discretion in the choice of accountingmethods. Managerial self-interest or a perceived need to protect the priceof stock can lead to the use of methods (such as of depreciation,amortisation, asset valuation) which will smooth, increase or decreaseincome.Accounting practice typically undervalues intangible resources.Alternatively, it ignores such assets because of the difficulty ofascertaining an objective value.

Short-term and long-term considerations

One problem for external users of accounting reports is the short-term biasbuilt into accounting measures. In some instances (such as research anddevelopment expenditure, or marketing expenditure), GAAP does not allowcapitalisation unless there is some degree of expectation or certainty that theexpenditures will result in revenues adequate to cover incurred outlays. Thisconservatism in asset recognition may discourage managers from acceptingprojects with negative short-term effects on profits, even though long-termprospects may be good.

Ex-ante and ex-post considerations

Accounting information is `ex-post': that is, it adopts a historical aspect inreporting on past events. Of itself, it provides neither external nor internalusers with prospective information. External users, however, use accountinginformation (from annual reports and supplementary releases of information)to confirm their expectations about a company's success. Internal userstypically use this historical information in strategic planning for subsequentperiods.

The inadequacies of accounting earnings

alternative accounting methods may be employed: different methods for

depreciation, inventory valuation, goodwill amortisation, and so onboth business risk (determined by the nature of the firm's operations),

SHAREHOLDER VALUE DEMYSTIFIED

and financial risk (determined by the relative proportions of debt andequity used to finance assets) are excludedaccrual based accounting numbers differ from cash flows fromoperationsdividend policy is not consideredthe time value of money is ignored.

Other shortcomings of using earnings are that they do not consider thequality of earnings (merely the quantity) or distinguish earnings derived fromoperating and non-operating assets. Further, earnings growth does notnecessarily lead to the creation of economic value for shareholders. If the rateof earnings is less than the cost of capital, then an increase in earnings will, infact, correspond with a decrease in shareholder value.

Inadequacies of accounting return on investment

Return on investment (ROI) is derived by dividing earnings by the totalinvestment in the corporation (that is shareholders' equity plus total debt).Whereas the earnings figure provides an absolute measure of corporateperformance, ROI provides a relative measure, as it takes account of theamount of resources used to generate the level of return.The ROI measure inherits the limitations of the earnings measure as it is,again, a measure based on accrual accounting. An ROI greater than the costof capital does not necessarily lead to an increase in shareholder value, as itdoes not necessarily follow that the cash flow generated will exceed the costof capital.As long ago as 1966, Solomon concluded that ROI is neither accurate norreliable when compared with a cash flow method discounted for changes inthe time value of money (known as discounted cash flow or DCF) for twomain reasons. Firstly, ROI varies from the DCF return to an extentdetermined by:

the length of the project life

the capitalisation policythe rate at which depreciation is recordedthe lag between investment outlays and the recoupment of these outlaysfrom cash inflows.

Typically ROI will understate rates of return during the early stages of aninvestment and overstate rates of return in later stages, as the undepreciatedasset base continues to decrease.Secondly, ROI is affected by the rate of new investment. Faster growingcompanies or divisions will be more heavily weighted with more recent

THE INADEQUACIES OF TRADITIONAL ACCOUNTING MEASURES

investment projects leading to higher book-value denominators. Thus, their

ROIs will be smaller than for a non-growth company investing at an identicalrate of return (Rappaport 1986, p. 34).

The inadequacies of accounting return on equity

Return on equity (ROE) is calculated in the same way as ROI, except that theinvestment figure used excludes the debt of the corporation. It shares all theshortcomings of ROI and, in addition, is more sensitive to leverage.An increase in earnings derived from new projects financed by additionaldebt will increase the measure, as long as the earnings are greater than theinterest cost of the debt. However, ROE does not take into account the factthat the increase in the debt increases financial risk, and decreases the valueof the business. Since the increase in financial risk increases the cost ofcapital, the company's economic value will be increased only if the additionaldebt generates a positive cash flow after discounting that cash flow by ahigher (risk-adjusted) rate. A focus on ROE will encourage corporations tocontinue to borrow to finance growth as long as the return is greater than thecost of the debt. To the extent that this return is lower than the cost of capital(that is, the weighted average of the cost of debt and the cost of equity),which has also risen along with the increased financial risk, the economicvalue of the firm will decline.G Bennett Stewart III, co-founder of the management consultancy SternStewart & Co., paints a very clear picture of the limitations of the accountingmodel, from which ROI and earnings per share are generated, as a measure ofvalue creation and, ultimately, as a guide to investment decisions. Using theresults of research into share price movements following changes inaccounting practices and the treatment of goodwill and expenditure onresearch and development, he offers evidence to demonstrate that share pricesare determined by expected cash generation, and not by reported earnings: `Acompany's earnings explain its share price only to the extent that earningsreflect cash. Otherwise earnings are misleading and should be abandoned asthe basis for making decisions ... and for determining (management) bonuses'(Stewart 1991, p. 28).

The superiority of market-based measures

Recently, the concept of shareholder value (the net present value of expectedcash flows discounted by the cost of capital) has gained prominence as abetter measure of enterprise performance. In addition, shareholder valuemetrics are claimed to provide:

10

SHAREHOLDER VALUE DEMYSTIFIED

a superior method of analysing and understanding `how much value the

corporation and each of its business units [are] creating for shareholdersand what the options [are] for improving performance' (Rappaport 1986,p. 52)a basis for restructuring and managing a corporation so that it createsvaluea means of sponsoring behavioural change in organisations towardsdecisions and actions consistent with shareholder wealth creation.

Shareholder value is supported by modern finance theory, which proposes

that economic value is the right yardstick for measuring businessperformance, since it reflects both risk and the time value of money.Broadly, shareholder value analysis is stated to provide a basis ormethodology for managing a corporation which will:

guide strategy formulation and selection at corporate, business unit and

operational levels of the organisationassist management in reviewing and questioning current strategies andexisting activities and structuresprovide the right criterion for pursuing business improvements andfocusing such efforts in the right directionprovide a powerful tool for setting priorities and, through a focus onvalue drivers, determine how to act upon themcreate value by redirecting managers' focus from accrual accountingbased profits and income statements alone to a focus on all the keyfactors that affect shareholder valuehelp set a focus on the key value drivers in the business.

CHAPTER

3RAPPAPORTSSHAREHOLDERVALUE ANALYSIS

Rappaport presents a method for estimating the shareholder value of the totalfirm or business unit. This includes current value (that is, value created in thepast), and the value expected to be created in the future. The `future' isdivided into a specific forecast period (in Rappaport's example, three years),and the period beyond the forecast period.

The components of shareholder value

The total economic value, or `corporate value', of a business entity is the sumof its shareholder value and its debt. Therefore:Shareholder value = corporate value - the market value of debt`Corporate value' is comprised of:

the present value of cash flow from operations during the forecastperiod; plusthe residual value of the business (including marketable securities) at theend of the forecast period.

`Debt' is future claims to cash flow and would typically include both shortand long term debt, capital lease obligations, unfunded pensions, and other

12

SHAREHOLDER VALUE DEMYSTIFIED

claims such as contingent liabilities. Debt is, in most cases, the accumulationof several debt instruments. The yield to maturity is used to calculate themarket value of each debt instrument which are then added. Note that the`market value of debt' is not the `face value of debt'. It is the amount thatwould have to be paid today if the debt were to be retired (Fera 1997).

The measurement of shareholder value

In order to determine shareholder value, its elements (cash flow fromoperations, residual value, and debt) need to be measured in present valueterms. This is achieved by using DCF analysis with the cost of capital as thediscount rate. These elements are determined as follows:

Cash flow from operations

Cash flow from operations equals cash inflows less cash outflows for theforecast period discounted by the expected cost of capital over the sameperiod.

Note: Rappaport (1986, pp. 53-54) defines the `operating profit margin' as the ratio of pre-interest,pre-tax operating profit to sales. Although a non-cash item, depreciation expense is not added backin this section of the calculation. Instead, depreciation expense is deducted from fixed capitalexpenditures in the calculation of fixed capital investment. Incremental working capital investment isthe net investment in accounts receivable, inventory, accounts payable, and accruals that isrequired to support sales growth.

The cash flow from operations for each year (calculated as describedabove) is then discounted by the cost of capital to compute present value. Thepresent values for each year of the forecast period are summed to give thevalue of cash flow from operations over the forecast period.The appropriate forecast period is an issue to be considered by eachorganisation or business unit. Although business plans are usually based onthree to five years, this period may result in inaccurate valuation if thebusiness plan period does not match what Rappaport (1986, p. 77) calls`value growth duration', that is, `management's best estimate of the number ofyears that investments can be expected to yield rates of return greater than thecost of capital'.

RAPPAPORT'S SHAREHOLDER VALUE ANALYSIS

13

The cost of capital

The cost of capital comprises the cost of debt and the cost of equity capital(the latter is typically called `the cost of equity'). It is determined bycalculating the weighted average of the costs of debt and equity capital. Forexample, if a business is financed 40 per cent by debt at an after tax servicingcost of 8 per cent, and 60 per cent by equity at an estimated cost of 12 percent, and this ratio is not expected to change significantly over the forecastperiod, its weighted average cost would be as follows:Weight (%)

Cost (%)

Debt

40

3.2

Equity

60

12

7.2

Cost of capital

Weighted cost (%)

10.4

The 10.4 per cent figure (the weighted average cost of capital or WACC)is the appropriate discount rate for this company to use, as it takes account ofthe claims of each group shareholders and debtholders in proportion toeach group's targeted relative capital contribution over the forecast period.

Cost of debtThe cost of debt is determined by taking the prevailing rate of interestcharged and the tax rate incurred, and allowing for any expected changesover the forecast period.

Cost of equityEstimating the cost of equity over the same period is more complex and isbased on the implicit rate of return required to persuade investors to purchaseor retain the firm's stock. The starting point for estimating the cost of equityis the risk-free investment rate: the rate that can be earned on governmentsecurities, in particular, long-term treasury bonds.As investors expect to get a rate of return that will compensate them forthe increased risk of investing in a specific company listed on the sharemarket (rather than in treasury bonds), a premium for equity risk iscalculated. This is the product of the market risk premium for equity (theexcess of the expected rate of return on a representative market index such asthe All Ordinaries Index over the risk-free rate), and the individual security'ssystematic risk: its `beta co-efficient':Risk premium = beta (expected return on market - risk-free rate)The value of the beta co-efficient is based on the degree to which the

SHAREHOLDER VALUE DEMYSTIFIED

14

individual security is more or less risky than the overall market. It is

measured by the volatility of its return in relation to that of a marketportfolio. Beta co-efficients for stocks are calculated by running a linearregression between past returns for that stock and past returns on a marketindex. (The beta co-efficients of all listed stocks are available from theAustralian Graduate School of Management at the University of New SouthWales.)In summary:Cost of equity

risk-free rate + the risk premium

risk-free rate + beta (expected return on market risk-free rate)

Security analysts use the Capital Asset Pricing Model (CAPM) to

determine the cost of equity for an individual company. The CAPM isdescribed in Appendix A.

Residual valueResidual value is the anticipated value of the entity beyond the forecastperiod. It often forms the largest component of a corporation's value. Its valuedepends on the assumptions made for the forecast period and an assessmentof the competitive position of the business at the end of the forecast period.There is no unique formula for determining residual value: differentmethods suit particular circumstances. For instance, an entity adopting aharvesting strategy during the forecast period would use liquidation values;whilst an entity seeking to build its market share during the forecast periodwould calculate a going-concern value.The Perpetuity Method is a going-concern method of calculating residualvalue. This method recognises that market dynamics will not allowbusinesses enjoying excess returns to continue doing so indefinitely.Eventually, such a firm will face new competition. The Perpetuity Method issuggested by Rappaport as one method of calculating residual (or terminal)value and is described in Appendix B. Other methods are:

the use of public information to assess the market's expectation for a

company's value growth duration (discussed in Rappaport 1986)the application to an organisation of Michael Porter's competitivestructure in the light of the five forces of industries (discussed briefly inFera 1997).

Valuing a strategyTo estimate the expected shareholder value to be created by particular

RAPPAPORT'S SHAREHOLDER VALUE ANALYSIS

15

prospective strategic investments in the forecast period, the method is to

calculate the value of the firm at the end of the forecast period; then subtractits current value (that is, the pre-strategy value):Value created by strategy = shareholder value - pre-strategy shareholder valueThe pre-strategy value is the current residual value of the business. It isbased on current data and does not include any anticipated value creationfrom the entity's prospective investments.

The drivers of value

Value drivers are the factors which drive value creation. Rappaport (1986)lists the financial drivers of shareholder value and presents a model of theway they relate to management decisions, valuation components (the factorsused in measuring shareholder value), and the corporate objective of creatingshareholder value.Figure 1Financial drivers of shareholder value (following Rappaport 1986)

CHAPTER

4STERN STEWARTSECONOMIC VALUEADDED MODEL

Since the beginning of the 1990s, EVA has become a widely advocatedmethod of measuring single period enterprise performance. The methodologyis claimed to be `the one measure that properly accounts for all the complextrade-offs involved in creating value' and therefore, `the right measure to usefor setting goals, evaluating performance, determining bonuses,communicating with investors, and for capital budgeting and valuations of allsorts' (Stewart 1991, pp. 136, 4). EVA is the spread between the rate of returnon capital and the cost of capital, multiplied by the `economic book value' ofthe capital employed to produce that rate of return.

Calculating EVAThe formula for calculating EVA is:EVA

(rate of return cost of capital) x capital employed

net operating profit after tax (NOPAT) (WACC x capital employed)

Note that this formula for evaluating the value created by an organisationor a business unit in the current year is identical to the formula to calculateResidual Income (RI) using WACC as the capital charge rate.

STERN STEWART'S ECONOMIC VALUE ADDED MODEL

17

As an example, for an organisation with NOPAT of $250 000, capital of

$2 million, and a WACC of 10 per cent:EVA

NOPAT (0.1 x $2 000 000)

==

$250 000 $200 000

$50 000

However, the figures for NOPAT and capital cannot be taken directlyfrom conventional accrual accounting based financial statements. SternStewart has identified a total of 164 possible adjustments. The consultancy,however, recommends making an adjustment only when all the followingapply:

it is likely to have a material impact on EVA

managers can influence the outcomeoperating people can readily grasp the purpose of the adjustmentthe required information is relatively easy to track and derive.

Adjustments to NOPAT and capital

Extrapolating from the formulae above:

This is, in essence, the ROE formula. The problems associated with this formulausing accrual accounting-based numbers are specified in Chapter 2. The adjustmentsto NOPAT and capital in EVA are designed to counter those problems. In EVA, suchadjustments are not confined to those required to convert accrual accounting basednumbers to cash. Rather, adjustments are also made to:

eliminate the effects of gearing (that is changes in the mix of debt andequity, as such changes confuse the effect of operating and financialdecisions)include other financing factors such as preferred shareholders andminority interests (since capital employed and NOPAT should include allproviders of funds)eliminate accounting distortions.

Some commonly made adjustments are:

1. To eliminate the effects of gearing: interest-bearing debt and the present value of non-capitalised leasesare added to common equity

SHAREHOLDER VALUE DEMYSTIFIED

18

interest expenses after tax on the debt and the leases are added toNOPAT.2. To eliminate other financing distortions: preferred dividends and minority interest provision are added toNOPAT the value of preferred stock and minority interest are added tocapital employed.3. To convert to cash-based numbers: taxes are charged to profit only when they are paid (thus alsorequiring adjustments to deferred tax reserve accounts) goodwill amortisation is added back to NOPAT, and accumulatedgoodwill amortisation is added back to capital employed (Thereasoning is that intangibles, if they are paid for, are not written offas they too must earn a return.) restructuring charges that involve cash payments, and gains or losseson dispositions of assets, are adjusted in NOPAT (by adding wherelosses are sustained and subtracted where gains are made, after tax)and in the calculation of capital employed provisions for bad debts and warranties, and other equity equivalentaccounts are excluded (by adjustments) as these practices amount totaking up losses in advance of their occurrence.Other adjustments to accounting-based numbers are necessitated, not inorder to achieve cash-based figures, but to reflect economic reality. Forexample, depreciation is not added back to profits in EVA. It is viewed as atrue economic expense reflecting the operational use of plant. However, if anorganisation's practice is to base depreciation charges on tax-basedconsiderations, rather than the operational use of plant, it should be reworked and adjusted in NOPAT and capital employed. Similar considerationsapply to research and development, and advertising and promotionexpenditures. These are not written off in one go for EVA purposes; ratherthe write-offs are spread across the estimated useful life of the expenditures.Marketable securities and construction in progress are subtracted fromcapital employed (and presumably any income statement effects are alsoeliminated) if these are not part of `operations'.A list of adjustments taken from The Quest for Value (Stewart 1991) isshown in Appendix C. Note that this list is based on United States GAAP andthus includes items (such as LIFO reserves) not applicable in Australia.

STERN STEWART'S ECONOMIC VALUE ADDED MODEL

19

The cost of capital

Stewart views the concept of cost of capital in the same way as Rappaport:WACC is used in EVA as in SVA. However, Stewart suggests that theimmediate past three-year period be used for the weighting process:As the minimum rate of return on capital required to compensate debt and equityinvestors for bearing risk, the cost of capital is the cut-off rate to create value. Thecost of capital is computed by weighting the after-tax cost of debt and equity bythe relative proportions employed in the firm's capital structure on average overthe trailing three years. (Stewart 1991, p. 743)The EVA calculation of the cost of debt and equity differs from that inSVA, in that the cost of debt is determined by the yield to maturity on afirm's own outstanding and publicly traded debt or, alternatively, on longterm bonds issued by companies of equivalent credit risk; and the cost ofequity assumes that the risk premium typical of common equities is 6 percent.

The drivers of value

The drivers of value in EVA are profitability in current operations, and theamount and cost of capital employed. Stewart (1991, p. 138) states that threestrategies will increase EVA:

improve operating profits without tying up any more capital

draw down more capital on the line of credit so long as the additionalprofits management earns by investing the funds in its business morethan covers the cost of the additional capitalfree up capital and pay down the line of credit so long as any earningslost are more than offset by a savings on the capital change.

Market Value Added

Whilst EVA is a single-period internal measure of a company's performance,Market Value Added (MVA) is a multiple period measure. Stewart (1991, p.180) describes MVA as:. . . the stock market's assessment at any given point of time, of the net presentvalue of all a company's past and projected capital investment projects. It reflectshow successful a company has invested capital in the past and how successfulinvestors expect it to be in investing capital in the future.It is therefore an absolute measure at any point of time. The change inMVA from one financial year to the next is equivalent to the EVA for thatperiod. If EVA is positive for the period, MVA will increase; if EVA isnegative for the period, MVA will decrease.

20

SHAREHOLDER VALUE DEMYSTIFIED

MVA can also be a cumulative measure of corporate performance. When

assessing past performance, the organisation can calculate the market valueadded (or lost) between two specific dates. Used as a forward-lookingmeasure, the MVA is the present value of anticipated EVAs with the cost ofcapital used as the discounting factor.MVA is calculated by the difference between a company's fair marketprice, as reflected primarily in its stock price, and the economic book value ofcapital employed:MVA = market capitalisation + borrowings - capital employedIt is important to understand that, as capital employed includes allinterest-bearing debt, that same interest-bearing debt must be added to marketcapitalisation to calculate the market value added. The methods of calculatingmarket capitalisation plus borrowings, and capital employed are providedbelow. However, in less precise terms, MVA can be thought of as thedifference between market capitalisation and shareholder's equity.Market capitalisation plus borrowings is calculated as:

the actual market value of ordinary shares at a date times the number ofshares outstanding; plusthe book value of:preferred sharesminority interestslong-term non-interest-bearing liabilities (except deferred income tax)all interest-bearing liabilities and capitalised leases and the presentvalue of non-capitalised leases (estimated by discounting the minimumrents projected for the next five years by the implicit rate of interest);minus

the book value of marketable securities and construction in progress

(because these items also are subtracted from capital).

Note that in the last two points above, book value is used. Stewart states:`Book value is used to approximate the market value of all items exceptcommon equity due to the absence of broad availability of quoted prices' (p.744).As shown above, capital employed is subtracted from market value toobtain MVA. Capital employed is the same as that used for EVA: details ofadjustments are listed under `Adjustments to NOPAT and capital' above(page 17). Broadly, capital employed is a company's net assets (total assetsless non-interest bearing current liabilities) with three adjustments:1.2.

Marketable securities and construction in progress are subtracted.

The present value of non-capitalised leases is added.

STERN STEWART'S ECONOMIC VALUE ADDED MODEL

3.

21

Certain equity equivalent reserves are added:

bad debt reserve is added to receivables the accumulated amortisation of goodwill is added back to goodwill R&D expense is capitalised as a long-term asset and smoothlydepreciated over a period approximate to the economic life of theinvestment in R&D (Stewart suggests 5 years).

While Stewart shows that MVA moves with EVA, other authors (forexample the Society of Management Accountants of Canada 1995, p. 22)point out that the former is sensitive to general market movements: `Weakcompanies can ride a rising market to big MVA gains that may proveephemeral, while robust performers can unjustifiably lose MVA if their sharesfall into a temporary rut'. This is undoubtedly true in the short term (witnessthe share market fluctuations in late 1997/early 1998). However, Stewartdefends the long-term efficiency and sophistication of the share market andquotes evidence to support his stand (see Stewart 1991, pp. 56-67).

Economic profitEconomic profit (EP) is similar to EVA, but does not involve adjustments toaccounting numbers. It can be derived from an equity approach:EP = (ROE - cost of equity) X book value of equityor from a total capital approachEP = (ROI - book weighted WACC) X book value of capital (Kilroy 1996).As single period measures which are based on book values or adjustedbook values (rather than market values), EP has its limitations. Nevertheless,such measures do, according to Kilroy (1997/98), give reasonably soundeconomic signals concerning strategy choices.EP is applied, not only to businesses and projects, but also to customers,customer segments, products and product packs.

CHAPTER

TOTAL SHAREHOLDERRETURN AND TOTALBUSINESS RETURNBoth these methods have been developed by the Boston Consulting Group(BCG). Total Shareholder Return (TSR) is what it says: the total return toshareholders that is, the actual capital gain from the beginning to the endof the financial year plus any dividends paid. It is an ex-post measure used bytop management and external users (investors) to compare an organisation'sperformance with the total market, or an appropriate index of peers.Total Business Return (TBR) is the internal proxy for TSR used byorganisations for assessing future plans, internal business-unit performance,resource allocation strategies, and for implementing long-term incentivesintended to drive changes in behaviour that generate increased shareholdervalue. TBR focuses on the factors which drive capital gains and dividends:profitability, growth through investment, and free cash flow.

ProfitabilityFor measuring profitability, the BCG suggests Cash Flow Return onInvestment (CFROI):CFROI represents the sustainable cash flow a business generates in a given yearas a percentage of the cash invested to fund assets used in the business. Theresult of the calculation can be expressed as a ratio if economic depreciation is

TOTAL SHAREHOLDER RETURN AND TOTAL BUSINESS RETURN

23

subtracted or as an internal rate of return (IRR) over the average economic life ofthe assets involved. CFROI is an economic measure of a company's performancethat reflects the average underlying IRR on all investment projects (BCG2, p. 33)

Calculating CFROI: the IRR method

The first step is to convert accounting data (income statement and balancesheet) into cash in current dollars. Adjustments, which will vary fromorganisation to organisation, are necessary. The process is as follows:1.

Allow for asset lives, that is the fact that firms have differing asset livesand asset mixes that are relevant to the performance, and so to the value,of each business. This step involves the calculation of the amount ofnon-depreciating assets (land and inventory, net working capital andinvestments) which would remain at the end of the depreciating assets'working life.Calculate the IRR. Use present value principles to find the discount rateat which:cash profit incomestream

non-depreciating assets+

released at the end of the

depreciating assets'economic life

current dollar gross

=

cash investment.

SHAREHOLDER VALUE DEMYSTIFIED

24

If the IRR exceeds the cost of capital in percentage terms, shareholder

value is created. The converse is also true.

The cost of capital

As with other value measuring approaches, TBR uses WACC. The formula is:

With regard to debt, inflationary expectations which are built into

prevailing interest rates should be deducted if the real cost of debt is to beused. An analysis of long-term bonds will reveal long-run inflationaryexpectations.For the cost of equity, BCG does not recommend the use of the CAPMmodel, which it claims contains two assumptions which are increasinglyunder challenge:

that relative volatility (beta) is the only factor affecting the way themarket discounts expected cash flows for an individual stockthat the market risk premium remains stable.

to current and expected future cash flows using its market-derived discountrate methodology, which prices equities like bonds:Under this method, current net cash flows are projected forward (for the marketas a whole), allowing for the average rate of company growth and changes inprofitability to move towards long-run averages. Armed with current marketcapitalisation and projected net cash flows (i.e. before interest, after capitalexpenditure), it is relatively simple to solve for WACC being applied by themarket. The equation can be approximately expressed as:

The schematic is shown on the next page.

TOTAL SHAREHOLDER RETURN AND TOTAL BUSINESS RETURN

* Spot value is BCG calculated value of a company based on CFROI.

BCG has observed three common failings when organisations apply costof capital concepts:1.

2.

3.

Internal inconsistency, through:

the use of debt rates that reflect maturities significantly differentfrom the expected life of the project or the depreciable assets the use of inflation assumptions that do not reflect the inflationaryexpectations inherent in prevailing interest rates which are used toestablish part of the discount rate mixing the treatment of tax (for instance varying between before taxand after tax numbers) in the cash flows and the interest rate used using book or proposed gearing of the particular project underreview, rather than target or normal gearing for the company inmarket terms.Using minimum hurdle rates: that is hurdle rates set at the cost of capital.These will only meet investors' minimum expectations. The objective ofmanagers should be to exceed this.Giving too much attention to cost of capital differences betweendivisions or business units. It is better to use a single discount rate,unless some business units have clearly different risk profiles.

Growth and free cash flow

Growth in invested capital producing CFROIs which exceed marketexpectations is the second strategy for the achievement of capital gains.Growth is promoted by free cash flow (also referred to as operating cash flow).At the corporate level, free cash flow pays for dividends, share repurchase, debt

26

SHAREHOLDER VALUE DEMYSTIFIED

retirement, or investment growth all of which have the potential to increase

TSR. It consists of net cash flow derived by the business units and madeavailable to the parent in a given year (BCG2). (Note that free cash flow is notrelevant to understanding a company's performance over a single year, as it isdetermined by discretionary investments in fixed assets and working capital.)

Projecting future cash flows

Stock market prices are the result of investors' expectations of a company'sfuture cash flows. Investors are aware that a company which has grown veryrapidly is not likely to sustain that rate of growth indefinitely. Similarly,companies which have been exceptionally profitable are unlikely to be able tosustain that level of profitability. Increased competition, new entrants into themarket or the advent of substitutable products will inevitably force profits tonormal levels. (Note the similarity between this view and Rappaport'sPerpetuity Method.) On the other hand, investors are also aware that,although a company's profitability may be affected by a cyclical downturn,the upturn will restore profitability eventually.BCG believes that companies with the primary objective of maximisingshareholder wealth must think like the market. Consequently, in projectingfuture cash flows, exceptionally high or low CFROI and investment growthare `faded' back to sustainable averages. This is termed the `cash flow fadeconcept'. It is particularly important when valuations incorporate highterminal values arising from growth or profitability assumptions beyond theplanning horizon.The application of this concept means that computing the value of abusiness, given only its latest reported performance, involves:

The drivers of value

As indicated above, the BCG methodology offers three value drivers: ROI,growth, and free cash flow. The return on invested capital can be increasedby either:

gaining increased return on existing capital

investing more capital at ROIs above the cost of capitalreducing capital at ROIs below the cost of capital.

The growth implicit in the second method can, to some degree at least, befunded by free cash flow.

CHAPTER

6COMPARINGTHE MODELSComparison to traditional accountingThe value-based models vary from the traditional accrual accounting-basedmodel in that the former:

use cash flows, rather than accrual accounting based numbers (EVA isthe exception with regard to depreciation)give equal weight to both income statement and balance sheet cashflows, rather than concentrating on income statement flowsuse discounted cash flows for decisions applying to entire businesses,rather than to capital spending proposals onlyuse the weighted average cost of capital, rather than the time value ofmoney, as the discounting factor.

Clearly, traditional accounting methods and the shareholder value

methodologies vary in complexity, in that the value-based models start withaccounting numbers and then make adjustments. Complexity is dependenton the number of adjustments: SVA is probably the simplest, followed byEVA, with TBR the most complex.

AccuracyIncreasing the number of adjustments to accounting numbers achieves greater

28

SHAREHOLDER VALUE DEMYSTIFIED

levels of `accuracy' in measuring performance. Accuracy, however, can be a

misleading word in this context. Organisations operate in product/servicemarkets which are characterised by strong competition, rapidly changingtechnology, and short product life cycles. Ambiguity and uncertainty aboundin a global world where both local and external events are often unpredictableand have widespread effects. In the midst of this level of change, organisationsestimate the effect on shareholder value of potential strategies, investments,projects, technologies, and so on by estimating future cash flows, and the costof capital. Behind these estimates are more estimates: of market size, marketshare, market growth rate, and selling price; of investment required and theresidual value of investment; of operating costs, fixed costs, and the usefullife of facilities.If the inputs to all value methodologies contain estimates, perhaps thelevel of accuracy, and therefore value to organisations, of each can be judgedby the degree to which the outputs of the measurement process correlate withstock prices. Academic research long ago established that the movement ofshare market prices, after allowing for general market movements, does notcorrelate with the financial information contained in annual reports unlessthat information has cash flow effects.Anecdotal evidence (for instance in articles in recent Australian businessmagazines, and BCG publications, or the convictions expressed by executivesof various companies using, or about to use, one of these methodologies)concerning the correlation of share market prices and calculated shareholdervalue measures suggests that, while all are good, the more complex themethodology, the better the correlation.Academic research of the correlation of EVA and stock market prices isinconclusive. Dierks and Patel (1997) report on three research findings: Lehnand Makhija found a significant positive correlation between EVA and MVAand stock market prices; a University of Washington study found that at bestEVA added `incremental information in some settings'; while Dodd andChen found that although stock returns correlated with EVA, the alignmentwas similar to that explained by residual income.

SummaryAs stressed previously, the use of value-based methodologies does not, ofitself, create value. What they, and indeed traditional accountingmeasurement techniques such as ROI and ROE, provide is a more or lessadequate indication of which organisational outcomes have an impact onshareholder value.Stewart (1991, pp. 75-76) summarises the shareholder view nicely:

COMPARING THE MODELS

29

... cost of capital can be used to divide projects and, in the aggregate, companies,industries, and even countries, into three categories:Group 1: Projects return more than the cost of capital. Because management canearn a greater return by investing capital inside the company than investors couldby investing in the market, value is created.Group 2: Projects break even in economic terms. The return earned just coversthe cost of capital, so that no value is created over and above the capitalinvested.Group 3: Projects, a favourite of many large, mature companies with cash to burn,return less than their cost of capital. Because the return earned on the capitalinvested within the company is less than investors could earn elsewhere, aneconomic, or opportunity loss is suffered and value is destroyed.In short, shareholder value will increase if the project generated a positivecash flow after either:

discounting the cost of capital (SVA and MVA)

subtracting a capital charge (EVA)comparing the IRR (adjusted for cash flow fade in the long term ifnecessary) with the cost of capital (TBR).

Table 1 provides a comparison of the shareholder value methodologies

described in Chapters 3, 4 and 5.Table 1A comparison of the shareholder value modelsFor use by investors and top managementUses

The measurement of shareholder value, of itself, achieves little except to alert

management to the fact that value is or is not being created, and to provide anopportunity to benchmark financial performance in shareholder value termsagainst competing firms. The next step, then, is to ask what organisationalchanges, initiatives or actions contribute to the achievement of the desiredoutcome of being, in Stewart's terms, a `Group 1' organisation.Proponents of shareholder value believe that the answer lies in theadoption of value-based management (VBM), which is described byCopeland et al. (1996, p. 97) as `an integrative process designed to improvestrategic and operational decision-making throughout an organisation byfocusing on the key drivers of corporate value'. VBM operates at corporate,business unit and operational levels. Corporate managers formulate strategiesbased on the creation of shareholder value by the organisation as a whole.Business-unit and operational managers select strategies, set targets, developtactics, design activities, and devise performance measures aligned tocorporate objectives. This alignment of the goal of creating shareholder value,strategy evaluation and selection, targets, tactics, activities and performancemeasures is claimed by Copeland et al. to be why VBM is superior to otherapproaches (such as TQM, flatter organisations, empowerment, Kaizen,team-building) to improving organisational performance.

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SHAREHOLDER VALUE DEMYSTIFIED

The drivers of value

In Chapter 6 the drivers of value for shareholders were identified as return,cash flow and asset growth. Underpinning these drivers are Rappaport's sevendrivers of financial value:

SHAREHOLDER VALUE DEMYSTIFIED

The challenge for the organisation, with a consciousness of the value

drivers that apply, is to:

evaluate and implement strategies at a corporate level which will

maximise valueflow these through to business unit and operational levels.

In this way, decisions and actions throughout the organisation are all directedtowards the objective of shareholder value.The number of potential value drivers means complexity in selecting thebest strategies/initiatives (that is, the ones which will have the greatest effecton shareholder value).The need, according to BCG, is not to identify which aspects ofoperations have an impact on value (since most do), but which have thegreatest potential for affecting the overall worth of the company. In BCG'sview, the most effective value drivers must satisfy two requirements:1.2.

their impact on value must be substantial, whether it be positive or

negativethey must be manageable by the business.

Sensitivity analysis and value mapping are techniques to measure the

impact of both negative and positive swings.

Strategy evaluation and implementation at corporate level

At the corporate level, strategy evaluation is generally concerned with thelong-term direction of the organisation and the scope of the organisation'sactivities, both illuminated by knowledge of the environment in which theorganisation operates. Such issues often involve decisions concerning theexisting or desired portfolio of investments, growth prospects, and relatedfinancing requirements.

USING SHAREHOLDER VALUE CONCEPTS

35

Portfolio analysis`Portfolio analysis' takes the view that a corporation is a portfolio ofinvestments, to be managed to produce the best total return. Over the last tenyears, many different approaches to the assessment of business units orsegments have been developed around the world. (For example, BCG's `stars,question marks, cash cows and dogs' classifications, McKinsey's 3x3 matrix:see Lewis et al. 1993, Johnson and Scholes 1997).Proponents of shareholder value methodologies claim that shareholdervalue-based analysis can indicate whether a business unit has been earning atgreater than the cost of capital. Wenner and Le Ber (1989) describe such aprocess. First, the original cost of each business and the incremental cashflows into and out of each business in the years between original investmentand the current year is ascertained. When discounted by the cost of capital,this provides a figure representing the total net investment in each business.Second, the economic value (net present value of future cash flows andterminal value) of each business is calculated. The difference between thesefigures is the shareholder value expected to be contributed by each business.A negative figure does not necessarily mean that a particular business shouldbe closed down or sold. However, it does mean that further analysis ofcurrent and prospective business strategies, operations and (perhaps)financing is required. It also raises the consideration of alternatives (such asthe feasibility of outsourcing areas of operation).In Australia, firms appear to be increasingly applying shareholder valueapproaches to the evaluation of business unit performance. Pacific Dunlop, adiversified manufacturing organisation, for example, has recently stated itsintention to measure each business within the group in EVA terms. Anybusiness which is not providing a positive return will be restructured in termsof size, focus and allocation of capital. If, after this, it still does not make thegrade then its sale may be an option (Knight 1996).Divestment decisions are not necessarily simple. Although each businessunit within an organisation may have its own unique competitive problemsand opportunities, there are often interactions between various business units.For example, an insurance company may have separate business units for lifeinsurance, general insurance, and superannuation but also a considerable`cross-sell' factor which may be lost in the event of the sale or closure of anyone of these three.

GrowthShareholder value analysis is also claimed to be useful in assessing thedesirability of growth in assets through expansion of existing activities,diversification, or acquisitions and takeovers. In broad terms, shareholder value

SHAREHOLDER VALUE DEMYSTIFIED

36

methodologies assert that growth will increase shareholder value only if thenew investments earn more than the additional cost of capital. QantasAirways Limited adopted this principle in 1997 when it considered theappropriateness of making substantial investments in new internationalaircraft. The decision was not to do so at that time but, rather, to lease for theshort-term or use surplus capacity of British Airways (its major shareholder)if necessary. The company's managing director explained that current lowmargins (resulting from strong competition in the Asian market) meant thatincreased investment in asset growth would actually damage the business asthe resulting profit would be less than the cost of the additional moneyinvested.A common way of achieving growth is through takeovers. In these cases,the reasons are often complex and based on expectations of operating benefitsand synergies (such as economies of scale, technical and managerial skilltransfer, control over supply or distribution) which may or may not eventuate.(Hubbard, in Lewis et al. 1993, lists 22 reported reasons for takeovers, onlytwo of which relate directly to earnings. Shareholder value was notmentioned.) Further, return and cash flow do not necessarily move in tandemin growth situations: growth may either diminish cash flows but maintain orincrease return, or increase cash flow but reduce return.Growth and risk are also interrelated. Black et al. (1998, p. 84) claim thatshareholder value methodologies do not recognise the relationship betweengrowth and risk (that is, the probability of actually being able to achieve theexpected growth rate):Many companies are now struggling to fulfil aggressive growth and valueagendas, but fewer recognise that taking risks is essential to both growth andreturn. Enterprises must integrate explicit measurements of risk into their strategicplanning in order to identify the possible organisational, cultural, and financialchanges that will be needed to achieve to achieve their SHV [shareholder value]and growth goals.

FinancingIn shareholder value terms, financing strategies are dependent on theavailability and potential return of investment opportunities, and the cost ofthe finance. Should opportunities not be available (so the status quo ismaintained) financing strategies would centre around the desired result ofreducing the cost of capital by either:

reducing capital requirements; or

changing the source and mix of debt and equity capital.

Share buy-backs (where corporations repurchase some proportion of their

ordinary shares from shareholders) are one means of reducing capital which is

USING SHAREHOLDER VALUE CONCEPTS

37

consistent with shareholder value principles, if growth opportunities of a

quality which will increase shareholder wealth are not available to thecorporation.Reducing capital through the retirement of debt is a question ofjudgement. One argument is that debt reduction, by reducing risk, mayreduce investors' required rates of return and therefore increase share price.However, as debt is the cheapest form of capital, a level of debt which is lessthan the optimal debt-carrying capacity of the organisation may in factdecrease share price.Changing the source and mix of capital may involve swapping debt forequity, debt swaps, revising terms of debt, and so on. In all cases, the aim isto optimise the gearing of the organisation.On the other hand, organisations may have numerous investmentopportunities, and ready access to funding through equity, debt, or an optimalmix of the two. The task then is one of making investment decisions whichwill direct resources to where they make the highest contribution toshareholder value.

Resource allocationOrganisations use economic value metrics to determine capital allocations tobusiness units by prioritising proposals or projects according to their abilityto increase shareholder value. Telstra Corporation, for example, intends touse EVA `to ration and better prioritise its huge capital expenditure program... with the aim of lifting shareholder value ... over the longer term' (Lewis1997, p. 7).Kilroy (1997) suggests that the management of value requires theestablishment of a value-based business planning and resource allocationmechanism, which he calls an `Internal Capital Market' (Figure 3 on p. 38):The [internal] market operates in a similar way to the external capital markets byallocating capital and other resources on the basis of value creation potential. It isbuilt around a strong business planning process which requires managers toconsider alternative strategies, value their businesses under each alternativestrategy, and build a business plan around the value-maximising strategy.The difference between this and other resource allocation models is theexplicit recognition that product markets (the source of customer value) andcapital markets (the source of shareholder value) are intimately involved inallocation decisions.

Setting targetsPart of the language of shareholder value is the incorporation into decisionmaking of financial performance measures that are consistent withinvestment at or above the cost of capital. `Hurdle rates' of return are a wayof establishing a target for key projects.

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Figure 3

Traditionally, companies have established hurdle rates for projects in

ROI, DCF or payback period terms. However, as mentioned in Chapter 2,ROI is typically not based on cash flow and does not consider the cost ofcapital, and DCF, which is cash-flow-based, does not ordinarily use the costof capital as the discounting factor. Payback is a relatively simple methodwhich uses cash inflows and outflows, but lacks precision in estimating theprofitability of projects and ignores the time value of money.The hurdle rate suggested by Rappaport (1986, p. 69) is the thresholdmargin, that is, the minimum operating profit margin (in cash flow terms) abusiness needs to attain to maintain shareholder value. Rappaport views it asa means of bridging the `valuation concepts of modern finance theory and theneeds of corporate decision makers [with] an easily understood, operationallymeaningful concept that enables managers to assess the value creationpotential of alternative strategies'. It needs to be remembered, however, thatat a rate of return equal to the threshold margin, growth will only maintainvalue, not increase it.

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While the threshold margin and other methods may be good overallguides, they are unlikely to be adequate for successful strategyimplementation. Targets need to be tailored to the level of the organisation(strategic business units, functions, operations), based on key value drivers,and expressed in financial and non-financial terms. Short-term targets (oneyear) are linked to longer targets (say, three years and ten years). The tenyear targets express the unit's aspirations, the three-year targets set the gameplan to achieve the planned progress over the longer period, and the one-yeartargets set the immediate goals. Such targets may be accompanied by actionplans which specify a series of steps the business unit will take to achieve itstargets.

Strategy evaluation and implementation at business unit level

Business unit managers also evaluate and select strategies from a range ofpossibilities. Within the bounds specified by corporate management, theytake strategic decisions about the markets in which the unit participates, thetechnologies and processes utilised, the allocation of resources (people,technology and capital) to areas of activity, and how the performance of thebusiness unit is to be measured and assessed.The strategy selection process at business unit level involves theidentification and clear articulation of the alternative strategies which thebusiness unit could pursue, as shown in Figure 4.Figure 4The strategy selection process at business unit level

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Probably, additional data gathering or market research will be necessary

before the valuation and the subsequent strategic decision can be made. Suchinformation is usually derived from:

market related analysis and data

By linking this information with value driver information, decisions and

actions which will enhance shareholder value are made.Market related analysis requires information related to customerrequirements or needs, industry structure and forces, competitor strengthsand weaknesses and, importantly, in-house organisational, resources, andskills competencies that can be leveraged to obtain competitive advantage inthe marketplace.Return requirements will typically be defined by corporate managementin terms of shareholder value added. Ultimately, returns depend on revenues(competitive prices) and costs. Costs are the results of operational decisionsin terms of the efficiency of activities and processes, and the effective use ofresource inputs (technology, fixed assets, working capital, people and so on).Product profitability analysis is conventionally determined using shortterm ROI measures, but may be more useful if based on cash flow projectionsover the life cycle of the product. There are various ways in which productprofitability can be improved. For example, resource consumption can bemanaged by reducing the costs of resource inputs, reducing the investment inassets, eliminating non-value activities, and/or improving productivity. Onthe revenue side, product differentiation can bring financial rewards bychanging customer perceptions. Synergies between products can provideincremental sales or differentiation advantages.Customer or customer segment profitability analysis is an examination ofwhich customers or customer segments provide most shareholder value, andanalysing whether to enter or exit particular customer or customer segmentsand/or shift resources between different products or different customergroups. Large organisations in Australia are typically undertaking customerprofitability analysis in terms of the differential economic value added. CocaCola Amatil Limited, for example, considers the economic value and growthpotential of its four major customer groups (foodstores, route, vending, andkey accounts), each of which displays differential revenue, cost, asset use andgrowth potential. A major bank segments its customers, identifies the needsof each segment, and designs and develops appropriate products which will

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create segment value. An insurance company takes an individual customer

approach, calculating a `potential lifetime value' on the basis of currentprofitability, potential profitability, and a cross-sell factor.

Linking shareholder value creation and performance

measuresThe strategic priorities and specific plans developed through value driveranalysis feed into performance measures. To determine appropriateperformance measures, organisations in one way or another establishfinancial and non-financial critical success factors (CSFs) or key performanceindicators (KPIs) linked to value creation. For example Qantas Airways:

develops key performance targets for all levels of the organisation, fromthe highest to the lowestlinks personal and departmental performance to the delivery ofshareholder value.

Another Australian company has, at group level, linked a balanced

scorecard approach to EVA in assessing business unit performance. Theprocess undertaken was described as follows:The group office wanted a set of about 16 measures from each of the businessunits and we wanted those measures to be consistent across the businesses sowe could see how each one is performing.So first we looked at our overall vision of the organisation. The next step waslooking at the strategies that the organisation as a whole had in place. And thenlooking at the four segments of the balanced scorecard as they support each ofthose strategies. A whole suite of measures was determined for each one ofthose strategies in the balanced scorecard approach. Then those measures(there were about 50 of them) were examined with regard to SVA. So all of themeasures that are in there in the SVA approach are consistent with the strategiesbecause that is how we got the initial fifty. And then the way you cull that down isto go back and have a look at which ones are going to have most effect on ourSVA. We selected 16. And so we have kept it consistent - balanced scorecard,SVA and strategic planning.The 16 levers or drivers are the important ones. There will be, of course, a wholesuite of backup drivers and levers. So if the business unit managements want todo a drill-down on what the group office say are the important ones, there mightbe four or five others that are important and then there might be four or five foreach of those. But the business units themselves will be identifying and workingon the backup drivers. The management of the businesses will be driving that.The best known balanced scorecard approach is that proposed by Kaplanand Norton (1996). This performance measurement methodology is claimedto have significant advantages in that:

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performance targets are derived directly from strategies and so

consciously focus on the critical areas of the businessfinancial measures, which report the results of actions already taken, arecomplemented by operational measures which are the drivers of futurefinancial performancetargets and measures cover a variety of perspectives: external (financialand customer) and internal (business processes and innovation andlearning).

Focusing organisational effort

Creating mindsetsThe shareholder value literature emphasises that long-term value creationrequires the cultural transformation of the organisation. All employees needto have a broad understanding of shareholder value, and accept thatshareholder value creation is the primary objective of the business.An equivalent term to value-based management, economic valuemanagement (EVM) is, according to Mayfield (1997, p. 32), a way to focusthe organisation and to improve communication and understanding byproviding a common `language':The great attraction of EVM is that, implemented effectively, it focuses the entireorganisation and helps avoid confusion since it is one measure which is easilyunderstood. Managers and employees are able to identify the key operatingdrivers for which they have responsibility because successful implementation ofEVM assigns accountability to lower and lower levels of the organisation. Theyshould be able to see how it links through into financial performance andtherefore economic (and shareholder) value. EVM is a very effective `language'which promises to ease communication and improve understanding both insidethe organisation ... and outside to shareholders and analysts alike.

TrainingThere is some debate about the degree to which employees at variousorganisational levels need to understand the mathematical aspects ofshareholder value methodologies (see the Case Studies). However, there isagreement that, at the very least, managers and employees need to understandwhat economic value is, how it can benefit the company, and how eachemployee can assist in its achievement. Corporations such as Coca-ColaAmatil and Qantas put considerable emphasis on educating employees in theprinciples of shareholder value creation, with the aim of encouraginginvolvement and changing behaviour.

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Incentive compensationThe last link in the performance loop of an organisation is the reward system.Organisations and commentators alike mention the opportunity provided byvalue metrics to align the interests of managers and shareholders throughincentive compensation. Indeed, Stewart believes this is perhaps the mostimportant aspect of the methodology.While doubtless important, the use of value metrics for incentivecompensation is not straight-forward. It is necessary to find the right balancebetween the rewarding (for the achievement of planned performance in thepresent) and motivating (seeking ever greater value creation in the future)aspects of incentive compensation.The Society of Managing Accountants of Canada (1995) quotes O'Byrne'sproposal for a scheme with three elements:

a target incentive award

The target incentive award ensures that managers are competitively

compensated for their efforts, thereby avoiding staff retention problems.While based on a labour market analysis, it is biased upwards because it islinked to the achievement of a target EVA. The fixed percentage interestcomponent applies only to EVA improvement above the target. The bonusbank aligns management and shareholder interests in that it exposesmanagers to risk the risk that they might suffer a negative `bonus'. Annualbonuses are banked forward rather than paid in full in the first year. In orderfor managers to cash in their bonus bank balance, they must continue toincrease shareholder value. The bonus bank smooths the ups and downs ofthe business cycle and extends forward managers' time horizon for decisionmaking.Joel Stern also seeks to align the long and short terms. He suggests thatmanagement and employees be paid bonuses (one-third in advance, with theremainder delayed) according to their business unit's contribution to EVA(Jeanes 1996). The concept of a percentage of compensation being `at risk',which is inherent in this suggestion, is becoming common in Australianorganisations.Kilroy (CFO, May 1998) suggests an incentive compensation systembased around incremental cash flow and value creation:In submitting a business plan built around the value-maximising strategy, ... thebusiness unit general manager is essentially saying to the CEO and the CFO `thisis the value (or cash flow over time) that I can deliver to you' ... If he or she delivers

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the promised value, and it is greater than the expected cash flow under thecurrent strategy, then value will have been created for the business. In someorganisations, this understanding is formalised into a performance contractbetween the GM and the CEO.Rewards, then, should be linked to increases in shareholder value over time. Fora listed company, the best way to do this is usually to focus on equity cash flow(which ultimately equates to dividends plus share price appreciation over time).For a non-listed company, the focus should be on incremental operating cashflow.One issue which remains open at present is the level or levels of theorganisation to which incentive compensation based on shareholder valueshould be applied.

CommunicationAs stated above, economic value concepts are believed to provide aneffective `language' which promotes understanding and communicationwithin the organisation.It is also claimed that the language is useful in communicating withinvestors, particularly the institutional investors who are the majorshareholders. (Institutional investors today own or manage on behalf ofclients a large percentage of the shares listed on the Australian StockExchanges). The benefits to corporations are that they can:

ensure that the market has sufficient and appropriate information to

evaluate the company at all timesuse the `right' (value-based) language in framing press releasesascertain how investors view a particular organisation's stock and thelikely reactions of fund managers to alternative strategies.

Two companies recently told ACMAD of the importance they attach to

communicating with existing and potential shareholders and understandingtheir expectations:Talking to the market about shareholder value is really trying to generate someoption value. If you can convince them that something different from the typicalfade model is actually going to occur, then you have option value. This is notrocket science. It is very simple stuff. TSR is the only model I have found that cangive me any guide as to how potential shareholders out there value our stock andtherefore a guide as to what we can do internally to try and improve that value.(Company 1)[Since adopting TSR] we have a better understanding of what the share marketexpects from us; and we are much better able to communicate with our largeshareholders about what we are doing and what our objectives are. (Company 2)

principally in their preoccupation with cash flows and their use of the cost ofcapital as the cut-off rate in determining value-adding investments. These twofactors, it is believed, are what the market is concerned about, and thereforewhat corporations should be concerned about. By aligning the thinking oforganisations and their shareholders, shareholder value methodologies areclaimed to:

provide a focus for all decision-makers within an organisation. This

single focus on shareholder value directs and simplifies decision-making(particularly in times of change and uncertainty) and encourages allorganisational members to `pull in the same direction'.provide a mechanism to facilitate the allocation of resources to areas ofan organisation which have the capacity to use those resources in amanner which maximises shareholder valueconstitute a performance measurement system which enablesbenchmarking externally, and the internal alignment of shareholdervalue, strategic planning, operational activities and reward systemsprovide a management system which is more comprehensive than othermanagement systems which have been proposed in recent years (such asquality, flexibility, empowerment, the team approach) in that economicvalue management can incorporate all these others and, with its ownshareholder value focus, use them in a more directed mannerprovide a `language' which facilitates communication internally andexternally.

There are, however, limitations. Successful implementation requires a

strong belief in one or another methodology by top management, and apreparedness to commit substantial effort and resources to drivingshareholder value thinking throughout the organisation.The methodologies are complex (some more than others) and differencesof opinion exist with regard to the `right way' to measure some elements. Forexample, BCG challenges the value of published betas, preferring a marketderived discount rate methodology. This consultancy also advocates the useof a single organisation-wide discount rate unless some business units haveclearly different risk profiles. The KBA Consulting Group, by contrast,believes that estimates of both the beta and the debt carrying capacity arenecessary for each business unit.The need for precision in calculations is open to debate. It is evident thatsome organisations take a less formal approach to calculating, for example,the cost of capital. When asked to describe how it calculated its cost ofequity, one organisation told ACMAD:

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What we do, we try to assume what our beta would be in regard to the marketaverage return. So the market average our estimation is that it is about 8% or7% now (August 1997) for the risk free rate the 10 year CommonwealthGovernment bond rate is the reference that you might use. The market premiumfor a listed company is approximately 5%. You might argue that it is not, but thenothers will argue that it is over the long run. So that's 12% and then we look at ourbeta in relation to that 5% excess. Is it a 0.8 beta or is it 1.2 or [what]? Now that'swhere there is a lot of subjectivity. I can't say what ours is - but there arearguments both ways, whatever it is. But we take into account how we feel aboutour organisation - is it blue chip? is it not blue chip? would people pay a premiumto be guaranteed a steady rate of return? what are the earnings we haveprojected into the future? are they steady? are they going to be lumpy? how is ourdividend flow? We would look at all those sorts of things to come up with what wethink our beta is, take into account dividend imputation, franking credits, etc. andthen bingo, you have got your cost of equity.

Another admitted `You can argue with the maths, you can kick itwhichever way ...' but nevertheless argues:... if I can get any form of model that gives me a better guide as to what theshareholder might do and the share price might be, then I'll use it. Because mostorganisations only ever look internally, and then they say `we've got all those youbeaut plans, why the hell aren't they in the share price?' But, of course, the guyout there can't see them. And to me there is real value in having some form ofanticipation of what the guy out there is thinking.Despite the adjustments made, shareholder value analysis is still based onaccounting numbers. Hence, soft assets (for instance organisationalcapabilities, organisational cultures and structures which foster knowledgetransfer and learning, the skills and know-how of employees, corporationreputation and customer base) are ignored. These are believed to have a largeimpact on profitability now, and an even larger impact on future growth andsustainability. Yet they are not captured in the balance sheet and shareholdervalue metrics do not include them in the asset base. (However, the value ofsoft assets can be captured by re-valuing the business in the managementaccounts at the present value of the expected cash flow under its currentstrategy, that is at market value.)Shareholder value methodologies underestimate creativity. Kilroy(1997/98, p. 165) believes that the emphasis on value drivers is overstated asthere is a limit to the extent to which costs can be reduced or revenuesincreased under the current strategy. New strategies are needed because thegoal posts are always moving:Management must continually seek to identify higher value strategies. As soon asa new and higher value strategy is communicated to the capital markets, the

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markets place a value on the new strategy. If the new strategy is well received,the company's share price rises ... The challenge then becomes to create valuefor those shareholders who invested at the new and higher share price. Thischallenge can only be met by continually bringing new ideas into play.We need to accept that shareholder value creation is a creative act, requiring acombination of creative and analytical thinking skills.Creativity should be grounded in analysis but should not be suppressed by it.

CASESTUDY

Coca-Cola Amatil Limited

Coca-Cola Amatil Ltd (CCA) is an Australian-based international beveragecompany and the most geographically diverse bottler of Coca-Colatrademarked products in the world. It is a very different company to thatwhich existed in 1989. At the beginning of that year, Amatil Ltd, as it wasthen known, operated tobacco, beverage, snack foods, communications andpackaging, and poultry businesses. A British tobacco company was its majorshareholder. By 1996 it operated solely in the beverage business, held andoperated Coca-Cola franchises in 18 countries, and had the United StatesCoca-Cola Company as its major shareholder. Its revenues in the 1997 yearwere $4.824 billion (compared with $842 million from its beverage operationsin 1989) and it employed approximately 40 000 people worldwide.

The origins of economic value at CCA

The enhancement of shareholder value has been an objective of Amatil Ltdfor many years. At the time of the re-organisation and the change of name toCoca-Cola Amatil Ltd in 1988/89, it was a very conscious commitment. DeanWills, the chairman and then managing director, commented as follows in the1989 Annual Report:The company's prime objective has always been to enhance the value of itsshareholders' investment. As the new Coca-Cola Amatil, we will continue to addvalue through the profitable growth of our businesses.This philosophy of long-term value creation through growth hadunderpinned the company's decision to divest itself of the broad range ofbusinesses it had operated in earlier years and concentrate on beverages. Itcontinued to guide decision-making about the best way to rapidly expand thebeverage operations.CCA does not distinguish between EVA and SVA, believing that`trademark' methodologies in this context are irrelevant. However, theexistence of trademark methodologies which employ different mathematicalformulae make a description of the measurement system used by a particularorganisation important. CCA uses accounting profit less a capital charge asthe measure of economic profit and the change from one year to the next asthe measure of economic value added. The cost of capital comprises the costof debt based on a target debt/equity structure, and the cost of equity. For thecost of equity, it uses the Capital Asset Pricing Model, obtaining its betafactor from a database at the Australian Graduate School of Management atthe University of New South Wales in Sydney.

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Economic profit and economic value added, however, are only two of awide range of measures used at CCA. Others include:

market shareaccounting profitreturn on net assetsnet present values.

The process in place

The term `economic profit' is frequently used in CCA. It is measured down tobusiness unit level in some areas of the company's activities (for instance inAustralasia) and to divisional level in overseas operations where thebusinesses are new and rapidly growing but as yet lack the requiredsophistication in their information systems to make measurement at businessunit level feasible.A great deal of thought and planning went into the process of introducingthe concept at business unit levels. Consultants were extensively used in theinitial stages for all the usual reasons - the desirability of having anindependent party involved, their usefulness as agents of change, the fact thatthey are extra resources, have different experiences, and so on. It wasconsidered important to appoint consultants who were in agreement or insympathy with the views of the company.A structured process was followed. It started with training sessions forbusiness unit managers: explaining the company objective of creatingshareholder value, what it meant theoretically, what it meant practically andhow to manage for its achievement. This was followed by a pilot projectusing the consultants, and eventually, the methodology was `rolled out' in anumber of different areas. The aim was to have managers who were thinkingin the same sort of format as the organisational centre that value is not justvolume, not just profit, but also a strategic awareness of the businessenvironment and a consciousness of the need to obtain an economic return onassets and, through a more concrete understanding of the economics,making better decisions.Over time the concept of economic profit has been introduced tooperational staff, using an explanatory manual expressed in simple terms.Another form of on-going education for staff has been the use ofpresentations in which pilot programs and their outcomes have beendemonstrated.Resistance has not been a major problem although there was initially acertain amount of scepticism from operations people. This was alleviated by

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the fact that the company has been successful in terms in share priceappreciation and many employees were current or potential shareholders as aresult of their participation in the employee share plan or in the optionscheme.Because of the company's corporate structure, internal disagreementsabout estimates did not occur. While management throughout the group isdecentralised, the Board retains authority over capital matters and head officefinancial people set the measurement rules. The cost of capital is calculated atcorporate level as it reflects the corporate debt-equity structure; hurdle rates,risk adjusted where appropriate, are also determined by head office;managers require head office approval for capital expenditure. Costallocations to operational areas are made only where those areas have theability to control the costs.

CompensationThe company believes that there is a relationship between compensation andvalue creation but regards getting that relationship right as difficult. Theapproach adopted by CCA is to provide incentives and to take a long termview. Share ownership by all employees through the employee share plan isencouraged. Share options, which have for some years been offered to seniorexecutives, are now offered to executives at lower organisational levels.In the near future, the company sees itself moving to a base level ofcompensation and an `at risk' portion, which may be a combination of bothcash and equity, plus longer term incentives through both the share plan andthrough options.

DiagnosticsThe cash concept which underlies CCA's approach to shareholder value isused to assess acquisitions, proposed initiatives, business development plans,and specific plans such as distribution channel development. There have beeninstances when evaluation has led to plans being reworked. On otheroccasions, evaluation has led to the acceleration of plans. However, anegative net present value does not necessarily result in the rejection of aproposal; nor does a positive net present value mean the expansion ormultiplication of an initiative. There are two reasons for this:

discounted cash flows necessarily contain assumptions about future

events. If assumptions are wrong, the answer may also be wrong.Therefore, it is imperative to understand the proposal and theassumptions behind it

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every firm operates in a strategic environment and there are sometimes

actions that have to be taken for strategic reasons, even if they do notstack up from a cash point of view.

With regard to the impact of new concepts or philosophies on systems, it

is considered that concepts always lead systems. Economic profit is noexception. Whilst the philosophy is entrenched in the organisation, theinformation systems are still catching up. The company is now at the stagewhere economic profit on individual product packs, calculated by a numberof different measures, is available on line. It believes it is further ahead than alot of companies in this regard. Currently, most of the focus is on getting theassets understood, accountability for, and control of them defined, andincorporating asset management into the existing systems.

Customers and suppliers

The company recognises that it is necessary to create value for its customersas well as for itself. In line with this view, initiatives have been undertaken inworking with trade customers to re-engineer processes. More importantly, thecompany feels that the use of economic profit has helped CCA managementto understand retailers' capital and asset structures and appreciate howretailers think.

ImplementationThe cost of capital is defined in head office and is given to operations.Corporate policy is that, for example, tax and treasury are best centralised. Sobusiness units are not making tax or funding decisions and are evaluated ontheir trading profit line excluding items such as interest and tax.No adjustments are made to account for the differences betweenaccounting and economic value. Indeed, this is not seen as useful as it is notcompatible with CCA's view that any measurement of value is an indicative,not particularly precise technique which is useful in relationship with otherpieces of information. It is felt that to go to extremes of accuracy is probablynot adding much to the picture, and that issues such as tax and tax incentiveshave little to do with general management operating decisions.Neither is using economic value or economic profit to measureperformance against other companies seen as useful. Internal benchmarkingagainst other operations within the group is, however, at a high level ofsophistication.Internally, economic value is regularly monitored at Board level and is anintegral part of financial planning and budgeting at corporate and operationallevels.

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LessonsAt the corporate level, the application of shareholder value principles hasbeen highly successful in CCA. Growth has been rapid, profitability good,and the share price has consistently outperformed the market. Internally, itsuse has facilitated organisational change and sponsored organisationallearning. For example, operational managers now appreciate the impact ofassets on value and sales people have a better understanding of the businessand are thinking differently. There is a common language, desirablebehavioural changes and a better level of internal debate.The following factors appear to have been instrumental in this success:

the concept of economic value supports the principal objective of the

companyit is the basis of organisational strategy formationit is a philosophy or belief which has provided a basis for consistentdecision-making throughout the organisationit has been consistently communicated internally and externallyit was introduced correctly, with commitment by top management, aconsistent approach, a willingness to start slowly and the persistence tokeep goingit is reinforced by the remuneration system.

In CCA's view, the calculation of economic profit and economic value

added is an outcome, the result of the company's approach to the market,strategic planning and investment decisions. But the philosophy ofshareholder value the long term expectation of future value creation must, in a decentralised operation, be the basis of all decision-making and anintegral part of the thinking of all employees. As one of the finance peopleintimately involved with the introduction of economic value explained:It is important that [employees] understand it, but not only understand it, but adoptit and believe it rather than just adhere to it. There is a difference. You are not justfilling out a travel expense form. It is a belief system and should influencebehaviour. From that point of view, ownership of the concept by all is critical. Ifyou don't have ownership, nothing will happen in terms of change.

CASESTUDY

Qantas Airways Limited

Qantas Airways Limited is a major player in the international and domesticairline business, ranking tenth in the world in terms of revenue passengerkilometres. In addition to passenger traffic, the company carries freight bothinternationally and domestically. Turnover is around $8 billion and marketcapitalisation at current prices (June 1997) about $2.7 billion. In the yearended 30 June 1997, operating profit before tax was $A403.7 million.Qantas commenced as a small privately-owned airline in Queensland on16 November 1920. The name was originally an acronym of `Queensland andNorthern Territory Aerial Services'. In 1947, the original company wasacquired by the Australian Government and Qantas became Australia'sinternational airline.Historically, domestic routes were covered by various privately-ownedairlines (notably Ansett Airlines Limited) and by another AustralianGovernment-owned airline, Australian Airlines (AAL). The government'sprivatisation programme resulted in the sale of AAL to Qantas in June 1992.In March 1993, British Airways acquired from the Australian Government a25 per cent stake in the now integrated airline. Then, in July 1995, the portionof Qantas still owned by the government was floated on the Australian StockExchange. The available shares were purchased by institutional andindividual investors.The view of Qantas top management is that, of its nature, an airline mustoperate as a network and that it is the network which creates value. Internally,the organisation is split into functional divisions: Airport Operations, AircraftOperations, Commercial, Associated Businesses, Information Technologyand Finance. There are several subsidiaries including regional airlines,island resorts, and catering organisations which, while managedindependently on a day-to-day basis, are viewed as part of the group and aresubject to central control with regard to investments, divestments, industrialrelations issues, policies related to image, and standards of safety.The airline industry is one where intense competition has led to graduallydeclining prices, yet large capital expenditure on new technology is a regularrequirement and the cost of inputs is constantly increasing. To increase, andeven maintain, profitability requires a continuous reduction in costs. Qantasseeks to achieve this through investing in projects which offer cost savingsand constantly revisiting the way it does business with regard to the type ofcustomer service provided, supplier arrangements, the use of informationtechnology which enhances efficiency, and work practices in every aspect ofthe business. Continuous improvement and business re-engineering is very

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much a way of life in the battle to be ahead of competitors, who are never farbehind in engaging in change.

The origins of wealth creation

In government-owned airlines in Australia, the prospect of privatisation hasbeen a powerful driver of change. In the late 1980s and early 1990s whenAAL appeared to be headed towards privatisation, there was an attempt toprepare the organisation for that event. With the help of the BostonConsulting Group (BCG) and under the leadership of the chief financialofficer and his staff, AAL began to adopt a value-based managementphilosophy. With the purchase of AAL by Qantas, some of the employeesmost involved in this initiative left the company and went their own ways. In1993, after the government's decision to privatise Qantas, they were broughtback with a clear brief to get the company ready for public listing. Again,BCG was part of the team.The focus of performance evaluation is TSR, a long-term measure thatlooks at capital appreciation plus dividends. This, the finance people in thecompany believe, is the ultimate performance measure which will bemaintained for the foreseeable future because it is the most accurate measureof wealth creation for the shareholders.TSR is a BCG-derived methodology which is claimed to be widelyaccepted, comprehensive, unbiased by size and suitable for benchmarking.Qantas's present group general manager for financial planning and controlhas watched its development since the late 1980s. At that time, he says, it wasa new idea and there were not many believers. However, as time has gone by,evidence of its worth has accumulated, and converts are now numerous. Inaddition to firms, a large number of institutional investors have adopted themethodology as part of their assessment procedures. The fact that analysts,investors, and management are now sharing the same philosophy is seen aspositive in that, if management delivers in terms of TSR, recognition byinvestors is certain.The drivers of TSR are profitability (ROI), asset growth, and cash flow.Profitability is cash-flow-based and termed CFROI (cash flow return oninvestment). It represents `the sustainable cash flow a business generates in agiven year as a percentage of the cash invested to fund assets used in thebusiness' (BCG2). The measure by itself is short-term in nature, and soignores growth. However, it has the advantages of including the entire assetbase required to generate cash flows (and so avoids accounting-baseddistortions, such as old assets, uncapitalised operating leases and intangibles)and measuring assets in current-dollar equivalents.

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A high CFROI alone, however, will not generate shareholder value. It is

necessary to use these returns to acquire more assets which, in turn, willgenerate further high cash flow returns. The methodology recognises that it isa combination of profitability and growth in business that generatesshareholder value.Free cash flow is the third driver of TSR. It can be used at the corporatelevel to pay dividends, repurchase shares, or retire debt, all of which canimprove TSR performance. At the business-unit level, it is the cash flowwhich is available to be returned to the parent for the purposes above or usedfor further asset growth.The following comment indicates the way in which Qantas has`operationalised' the TSR philosophy:For investment appraisal, we use discounted cash flows and discountedpaybacks but, if the investments are large, they form part of our longer termplanning we have a three-year corporate plan and, in view of the life of ouraircraft assets, longer term plans and we assess the impact of the investmentson the forecast TSR. We use a modelling technique to forecast what our shareprice is going to be in the future. That forecast and the dividends we pay tells uswhat the TSR in the future is going to be. Our aim, when assessing investments,is to ensure that the TSR generated out of those investments is one that willsatisfy the minimum requirements of our shareholders.It is obvious that, if shareholder value is to be enhanced, the TSRgenerated by investments must exceed the cost of equity. At Qantas, the costof equity is assessed using the BCG methodology, which derives the costfrom the marketplace:By looking at the cash flows generated by a business and the value that themarket puts on the investment and the cash flows, we can calculate whatinvestors believe the return on equity should be. If the cash flow is lower thananticipated, shareholders through the market mechanism adjust the price toreflect what they perceive to be the risk associated with the company'sinvestments and their required cost of equity.We've used an analysis of our current market price to determine what our cost ofequity is but, of course, it is not only cash flows and the cost of equity thatinfluences share price in the short term; there are things like market sentiment.We have also looked at the cost of equity of other airlines in other markets and atmore traditional approaches such as the Capital Asset Pricing Model (CAPM).There are all sorts of experts out there who can tell you what your beta will be butwe tend to avoid CAPM as we are convinced that the market-derived cost ofequity is more appropriate.

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But the ultimate check was talking to some of our large investors and talking withtheir analysts at a more educated level to try to find out the type of returns thatthey are expecting, given the type of industry and the gearing. The one largefactor coming out of it is the relationship between the leverage of the companyand the required returns. The debate about the impact of gearing on share priceis not settled. Some believe that, if leverage is reduced by, for example, raisingequity, there will be a negative impact on earnings per share and a reduction inshare price. The other side, with which we agree, is that lower gearing meanslower risk and, if the cash flow generated out of the business is the same, thevalue of the shares will increase. Although raising equity capital may causeearnings per share to drop, shareholders are, we believe, concerned about longerterm value creation and a lower earnings per share does not automaticallytranslate into a lower TSR.

The combination of cash flow return on the current value of investments

and growth in assets is seen as vital.

The process that is in place

Impending privatisation was the factor that led the finance director and histeam to ask questions such as: Who are our new owners? What are theirrequirements? How do they measure performance? This led to theories ofvalue creation and the need to manage the company in a way that wouldcreate value. Then followed a lengthy study of the way in which the companywas managed, the types of performance evaluation that it was managed byand the tools that were employed. One result of this was the establishment ofTSR at the corporate level. Another was a total transformation of themanagement and reporting processes to ensure that everything was consistentwith the TSR objective.At corporate level and at operational level, Du Pont-style analyses areused to define the value drivers. These are, of course, structured in differentways but all are directed towards TSR elements. Sensitivity analysis wasemployed to identify which value drivers add most value at the end of thechain. From these value drivers, the company has developed key performanceindicators (KPIs) and tracks, through the Du Pont analyses, the link betweenan improvement in a KPI and the impact on value.Currently, Qantas has three levels of reporting, all of which are directedtowards TSR-related performance measures:

to the Board of directors

divisional reports to the managing directorat operational level.The use of teams, both cross-functional and in individual functions, hasbeen extensive in developing KPIs and designing Board and management

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reports, as well as in initiatives to improve efficiency and re-engineer

processes.There is a formal three-year planning process both at corporate and atdivisional level. Once the plan is approved, it is dis-aggregated into thebudget for the first of the three years. Because of the company's investmentsin aircraft with a life of 20 years or more and a discounted payback of around10-12 years, longer-term forecasts are also prepared. In addition, the formalcorporate planning process for the three year period looks at wealth creation.The calculations are based on traditional accounting statements but thenumbers and statements are converted into cash flows, as described earlier, sothat they provide the value-added and the TSR. As indicated earlier, thesenew planning processes have impacted on investment decisions.

Implementation issuesAcceptance roadblocks to the introduction of the shareholder valuemethodology have not been encountered although there was initially a certainamount of scepticism and a lack of understanding. Whether or not it isnecessary for managers at divisional level to have a full recognition of thebenefits of the TSR philosophy is questioned. Although it is essential thatmanagers understand and accept that the ultimate objective of the company isto deliver value to shareholders and that the KPIs are directed towards thisaim, it is doubtful that they need to understand the details of the link betweenthe KPIs and TSR.Although continuously investing heavily in this area, Qantas agrees withcomments made by other companies that information systems are `never upto scratch' as far as adequacy goes. Whilst the historical information providedis regarded as good, the perceived need now is for information systems whichpredict the future, thus allowing management to take actions to ensure thatthe future is what the company wants it to be. One example is the yield(quality of earnings from passenger traffic) management system: where onthe basis of past patterns of demand, the company forecasts what the demandis going to be in the future and takes action in the marketplace to obtain afavourable result.The impact on suppliers and customers is generally good. Customer valueis the focus of some of the KPIs selected as it is through customers that theshareholders get their returns. Nevertheless, there are occasions wherecustomers expect to receive a level of servicing the full cost of which they arenot willing to pay, and in these cases shareholders do not benefit. The issue isseen as one of balancing customer needs and wants and shareholder returns.Value-based management in itself is not seen as affecting relationships

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with suppliers. It is more the focus on costs that has resulted in relationshipswith suppliers becoming more straight-forward and honest.Compensation issues: At the time of the float, each employee received$500 of shares in Qantas Limited. This value was dictated by the tax laws atthe time. Since that time, a further $500 share issue has been made to eachmember of staff.All executives participate in a performance-based reward scheme thatprovides for cash performance bonuses. The bonuses are paid on theachievement of pre-determined objectives, including planned profit levelsand/or revenue improvement targets.Executive directors and certain senior executives also participate in anExecutive Incentive Plan, which provides for a bonus which is related toQantas's TSR ranking amongst the top 100 listed Australian companies, andthe TSRs of a pre-determined basket of international airlines listed onoverseas stock exchanges.

The value of the TSR concept

The introduction of TSR has been quite costly in terms of commitment andeffort. However, this cost is seen as worthwhile:We have an excellent understanding of the concepts; we have a better planningframework; we have better reporting; we have a better understanding of what theshare market expects from us; and we are much better able to communicate withour large shareholders about what we are doing and what our objectives are.To us, the main thing that came out of TSR was the importance of growth in anystrategy. It wasn't a matter of whether we grew or stayed as we were. It was amatter of finding out what creates value. And this is a combination of growth inprofits and growth in the size of the business.We believe that all firms should try to understand what makes their share pricesmove the way they do and work from there to develop strategies that will delivervalue to their shareholders. They need to understand their cost of capital and costof equity, the gearing aspect and how all that impacts on the required return toshareholders. And then bring it in-house and start working on developing strategiesthat will deliver the cash flows and the growth that the shareholders want.

CASESTUDY

RGC LimitedRGC Limited (RGC) is an Australian listed company engaged in the miningof mineral sands, tin, gold, coal and base metals. Its origins go back manyyears to a time when a number of different organisations were engaged in themining of various metals around Australia. In the early 1980s, thesecombined to form one group. Over recent years, the company has pursued agrowth strategy, exemplified by the 1996 takeover of Pancontinental Ltd.The group has 13 active mining sites in Australia, Papua-New Guinea andthe United States. In addition, it undertakes exploration in South America, SriLanka, Africa, Australia and Papua-New Guinea.The management structure is devolved, with each mining site having agreat deal of autonomy. A small head office in Sydney, however, keeps aclose eye on capital expenditure. For short-term planning, RGC uses a rolling24-month forecast which is adjusted quarterly to adjust for latestexpectations. The forecasts lead directly to the setting of targets for each ofthe company's mining sites. These targets are set and monitored by thegeneral manager of each site and an executive committee member. Theyincorporate a degree of `stretch' and thus motivate, focus on controllablevariables (production levels, cost, and safety), and are the basis for a variablecomponent of the remuneration scheme. Longer term planning is undertakenthrough an annual strategy review which involves the Board of directors andis based on long-term site planning.Although long conscious of the need to provide value to shareholders andaware of economic value techniques, RGC has only recently begun toinvestigate the adoption of the BCG's TSR/TBR methodology.

RGC's current methods

RGC uses a composite of profit-based measures (accounting profit, return oninvestment, return on equity, and earnings per share) to assess corporateperformance. Net present value, internal rate of return and the paybackmethod are used for asset acquisitions, make or buy decisions, and businessacquisitions and mergers. The most pervasive method for ongoingmanagement is a sophisticated Du Pont analysis initially introduced to theorganisation some years ago by the BCG and now an integral part of theoperations.The Finance Director described what he found when he joined RGC:The Du Pont Charts covered corporate, divisional and operational levels. At eachlevel, the components were taken out to the right, and actually broken down

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through the whole organisation so that there were key performance indicators atall levels. Every function was covered maintenance, production, accounting,etc. Because of all the little lines drawn on the charts, they became known as`Plumbing Charts'. Amazing. I hadn't seen any other company do it to that level ofdetail.

The high-level components of the Du Pont charts have for some yearsbeen the basis for monthly Board reporting which focuses on profit, cashflow, return on operating assets and key performance indicators. Thecompany has found this a useful way of capturing the major performancemeasures, financial and non-financial, for each operation. In addition, it hasbeen seen as:

appropriate for the businesses in that it provides managers with the

necessary information to manage their businessesunderstandable to operational peopleencouraging an `ownership' mentalitysponsoring a consciousness of operating assets, costs and cash flow.

Cost, in particular, is important to mining companies which are mainly

price takers on their products. The price element in revenue is largelyuncontrollable as it depends predominantly on the world market price for thevarious metals and on the United States-Australian dollar exchange rate. Thefocus then is on what can be controlled: cost, and being on the low end of thecost curve for the industry. The logic is simple. There will be commodity pricefluctuations, and companies with the lowest costs are likely to survive longer.At the strategic level, the company calculates the cost of debt on a groupbasis, not at divisional or operational levels. To charge a rate of interest to adivision has traditionally been seen as just another set of allocations. Thus,instead of allocating a capital charge to divisions, the company takes thedesired return on shareholders' funds and converts that into an appropriatelong-term return for each division. Although a rule of thumb, experience hasshown this to be a reasonable approximation and something that people canunderstand.The optimal level of debt is also considered to exist only in a conceptualsense. Practically, the level of debt is seen to be a function of the availableprojects/investments that the organisation wishes to undertake. If the demandfor capital is low, it does not make sense to borrow more than you need. Ifthe demand is great and cash flow expectations from new projects areadequate, the organisation may go above its theoretical optimal level for aperiod of time.Of course, not all investment decisions are straight forward. Theestimated cash inflows and outflows and the discounting rate applied arenecessarily based on assumptions about an investment that can be variable to

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a substantial degree. If a project or investment is extremely good and offers

substantial returns, the fact that the calculation is not exactly accurate doesnot matter. If it is marginal, the validity of the assumptions is very important.It is reasonable to say that `simplicity' and `understandability' have longbeen the watchwords at RGC. Unnecessary complexity and intricacy are tobe avoided.

The reasons for considering the adoption of the BCG

methodologyRecently, RGC has become disenchanted with the use of accrual accountingbased numbers as the basis for future planning. The company's financedirector believes that the existing strategic process does not adequatelyrecognise value lost or value created, or provide an adequate basis fordecisions about investments. Two points at issue are investment decisions inexisting mines and the treatment of exploration costs.With regard to investment decisions in existing mines, he commented:We have in some cases been spending money chasing volume and not necessarilyvalue. You can get caught up in the reinvestment trap. You've got an ore bodywhich is declining and the costs are going up and the revenue coming down. Youhave invested so much in it and if you don't spend some more money, themine will stop. But if you do spend the money, you know that you will not recoupthe additional investment. We need a new way of looking at these decisions.Exploration costs are expenses, according to RGC. To capitalise suchcosts and carry them on the balance sheet may lead to fluctuations in profitresults, as exploration costs need to be written off if no ore body is found.The result is that profit fluctuates, not as a result of operational factors butbecause of success or failure in exploration.However, the major asset of a mining company is the ore in ground and,as it is mined over time, the asset has progressively less and less value. Inmining, the critical issue for the long term is that reserves are replaced so thatthe firm stays in business. Companies must either discover or buy resourcesso that they can maintain their productive capability. Clearly, exploration hasvalue and is an investment for the long term future of the organisation.Indeed, in assessing the success of an organisation in the resources industry,successful exploration is a major component.The RGC accounting treatment (expensing exploration expenditure),whilst very conservative, does not reflect such value on the balance sheet.This leads to potential misunderstanding of the nature of the expenditure bydecision-makers both within and outside the organisation. The answer is notnecessarily to capitalise exploration expenditures on the balance sheet but,rather, to ensure that the value of such expenditures is recognised in strategicdecisions.

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These issues led the company's top management to rethink the strategicprocess and to consider the adoption of a different perspective on investmentstrategy. Accordingly, BCG were consulted and the company is currentlyconsidering the adoption of TSR and CFROI at the corporate level. Theadvantages are seen as:

the BCG methodology's capacity to develop a model that has the abilityto, with some reliability, predict share price and thus provide insights onthe gap between where a firm is and where it needs to be if it is to becompetitive on a shareholder return basisthe enhanced ability of the organisation to make portfolio decisionsbased on valuethe enhanced ability to plan for the creation of option value whichshareholders will incorporate into share pricethe ability to monitor the group's performance against that of its peers ona TSR basis. This is especially important in the mining industry because,as in any cyclical industry, there are times when TSR will be negative.The critical performance issue is whether you are doing as least as wellas your peers.

IssuesRGC questions the need to change in any substantial way its performancemeasurement structure at business unit level:I don't know that it is important to take shareholder value-based measures rightdown through the organisation although there do need to be linkages tooperational performance. There has to be people at the edge between strategyand operations and those people will have to cross the hurdle between one andthe other. We are going to have to think carefully about how we build theselinkages. What you need is effective decision making and performance monitoringthroughout the organisation, which meets the operational needs yet can bedemonstrated to add shareholder value.To me this is all about the measures and getting them to link in a hierarchy. I don'tbelieve the dis-aggregation (from corporate to divisional to operationalmanagement) has to be:(i) perfect; or(ii) complete.The points that really matter are that your people understand the linkages andmake better decisions. This means keeping decision criteria and performancemeasures simple.

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Compensation is another issue. For some time in RGC, a percentage of

every employee's remuneration has been `at risk', that is dependent upon theperformance of the division against key performance indicators. Theseindicators at the operational level include output, safety, and cost per unit ofoutput and will not necessarily change. However, the company believesthat, if TSR is to be introduced successfully, it should be the primary measurefor executive incentives:I don't think anybody has ever got executive compensation right in terms ofincentive payments. There are, and always were, times when executives win andtimes when they lose. There is no such thing as a perfect system. The best youcan do is to focus executives on the critical drivers. Get executives focused on theright things and the inequities over time should balance out.RGC was at an early stage in its investigation of shareholder valueconcepts when it merged in late 1998. The company's thinking at that timepointed to the need for shareholder value methodologies to be flexibleenough to suit different businesses' need or desire for simplicity versuscomplexity, precision versus approximation, and perfect versus partialintegration throughout the organisation. As the finance director said: `It'sabsolutely useless putting in complex measures if people can't use them tomake better decisions. It defeats the purpose.'

APPENDIX

The Capital Asset Pricing Model

Calculating the cost of equity capital brings us more deeply into the world offinance theory. The staple tool of security analysts in determining the cost ofequity capital is the Capital Asset Pricing Model (CAPM). CAPM is an`idealised portrayal of how financial markets price securities and therebydetermine expected returns on capital investments. The model provides amethodology for quantifying risk and translating that risk into estimates ofexpected return on equity' (Mullins 1982, p. 105).The model is based on a series of simplifying assumptions and thecategorisation of risk into two types: systematic and unsystematic.Unsystematic risk is the risk that is peculiar to the company and can bediversified away by holding a portfolio of shares. Systematic risk is theportion of risk related to the movement of the share market that cannot bediversified away. Consequently, for investors with well diversified portfoliosonly systematic (that is, market) risk matters (Mullins 1982, p. 107).To measure systematic risk, financial analysts normally use the stock'sbeta factor, which can be regarded as a measure of the stock's volatilityrelative to the market's volatility. For example, a stock with a beta of 1.00 an average level of systematic risk rises and falls at the same percentageas a broad market indicator such as the All Ordinaries Index. Theseconceptual building blocks culminate as the CAPM risk/expected returnrelationship (based on the proposition that only systematic risk measured bybeta matters).The CAPM states that stocks are priced such that:Rs = Rf + risk premiumRs = Rf + Bs(Rm - Rf)where:Rs = the stock's expected return (the company's cost of equity)Rf = the risk free rateRm = the expected return on the share market as a wholeBs = the stock's beta.The risk-free rate is the return on a risk-free investment such as a treasurybill. The risk premium is measured as:beta X the expected return on the market the risk-free rateAs the financial literature generally defines the cost of equity (Ke) as theexpected return on a company's stock then the CAPM model can be used toobtain an estimate of the cost of equity:

The Perpetuity Method

The Perpetuity Method provides a means of calculating the residual value ofan organisation which is going concern. It is based on the assumption thatmarket dynamics will mean that new businesses enjoying excess returns(above the cost of capital) will eventually face new competition. This in turnwill create excess capacity, drive down margins and reduce the returns of allcompetitors in that industry to the minimum acceptable or cost of capital rate.The method assumes that after the forecast period the business will earn,on average, the cost of capital on new investments. In this situation, periodby-period differences in future cash flows do not alter the value of thebusiness. As a consequence these future cash flows can be treated as if theywere a `perpetuity' or an infinite stream of identical cash flows (Rappaport1986, p. 61).The present value of a perpetuity then is the value of the annual cash flowdivided by the rate of return as follows:

Using the perpetuity method, the residual value is determined as:

For example, say the Company X generated $25 million in cash flow in theprevious year. If it were to continue to generate $25 million annually intoperpetuity, and its cost of capital is 12.5 per cent, the value of the companywould be equal to $200 million, that is:

APPENDIX

Adjustments to capital and NOPAT in EVA

The following is adapted from Stewart 1991, p. 112. For further detailsregarding the nature of these adjustments, refer to pp. 113-17 of this source.For EVA calculation, add the following to `capital':